Behavioral Psychology Strikes Again

Sarah F. Roach

On May 7th, the Dow dropped more than 473 points—nearly 1.8%. On May 13th, not even a week later, it dropped another 617 points, or about 2.4%. What was that all about? Was it the harbinger of an imminent crash? Probably not, given that all that lost ground had been recovered a month later. If you’d been off the grid for the month, you might well have thought the market had been calm in your absence.

In response to the recent volatility, on May 17thWall Street Journal columnist, Jason Zweig, wrote about how steep declines can trigger predictable psycho­logical reactions in investors. As Zweig said, “…big market moves, like flash bulbs that go off in your face, do blur your vision—whether investors realize it or not.” Two cognitive biases are probably at work here: recency bias and negativity bias.

Recency bias refers to the fact that more recent infor­mation is better remembered and receives greater weight in forming judgments than does older infor­mation. Negativity bias is the notion that negative events have a greater psychological effect than neutral or positive events. When a negative event has recently occurred, investors must cope with a psycho­logical double-whammy. Yale economist—and Nobel Laureate—Robert Shiller’s Stock Market Confidence Indices demonstrate how both biases influence our reaction to large market drops. These surveys show that investors are more likely to fear an imminent market crash immediately following a steep decline. The March 2009 survey, for example, indicated that more than 80% of investors surveyed feared a crash in the following six months. Anxiety and pessimism had been triggered by both the recency and negativity of the prior 50% market drop. As we now know, however, March 2009 marked the bottom of the bear market, and the subsequent six months saw U.S. stocks gain 32%.

With the Dow hovering around 26,000 today, big market moves—point-wise—are more common than in the past, but investors continue to see them as rarer and more alarming than they typically are. According to Jason Zweig, the Dow has dropped at least 2% in a single day more than a thousand times since 1896. This statistic suggests that a drop of at least 520 points once every six weeks or so should not be cause for alarm or require special explanation.

Unfortunately, logic and historical precedent get overwhelmed by our human need to attach a reason to large market moves, even when there may not actually be one. Beyond that, once a plausible explanation receives media air or print time, it tends to acquire a sheen of truth it may not deserve. As Professor Shiller says, “Narratives have a certain exogenous life of their own. It’s just contagious.” A telling—and amusing— example can be found in the 617 point drop on May 13th. The talking heads ascribed the decline to the snail-slow pace of trade talks with China. Terrible news, right? Only until you read their analysis of the equivalent gain that occurred between May 14th and 16th: Apparently the market rose on the great news that trade talks were creeping forward. Shoot dart, paint target. You gotta love behavioral psychology!