The Psy-Fi Blog: The Proper Etiquette for Market Panics

Don’t Eat Soup With a Fish Knife

When we’re operating in situations we’re not entirely sure about we follow a simple rule of thumb: we copy what other people are doing. So if we’re attending a fancy dinner with a place setting of sporks and splayds we’ll probably do whatever the people next to us are doing, in an attempt to look as though we understand the proper etiquette.

Which works beautifully as long as someone knows what to do, but can be disastrous if no one has a clue. Which is all the explanation we need to understand why, currently, investors are trying to eat soup with a fish knife.

Herding’s Too Familiar

We know that herding is a common investment behaviour, where people tend to all charge in the same direction – the kind of thing we looked at in Herd of Investors. Everyone’s at it, and simply exposing people repeatedly to ideas leads people to assume that they’re true. So if you hear that the world’s about to go to hell in a handcart often enough you’ll start to adopt this viewpoint yourself, regardless of the fact you probably wouldn’t recognise a handcart if it came up and bit you.

This seems to be based on some kind of familiarity bias, which works on the basis that familiarity is a useful cognitive short-cut that means we can avoid the hard work of actually thinking for ourselves: see, for instance, Fooled by Fluency which shows that the more “obvious” an idea is then the less work we actually put into thinking about it.

No One Knows Anything

In our mass media dominated world it’s no surprise that extreme views get the most exposure: it’s very rare that a quiet day on the stock market or a nonaggressive handcart gets reported. So it’s easy for people to become familiar with the idea that everything’s going badly wrong and to mistakenly overreact: to sell all their lowly priced stocks, buy an assault rifle and barricade themselves in the nearest cave complex with a decade’s supply of iron rations, for instance.

All this we ought to know, because all this is common knowledge. Intelligent investors understand that market movements, no matter how extreme, don’t necessarily mean that anyone knows anything. And, regardless, the more extreme the pricing movements the more likely there are to be outstanding bargains amongst mispriced stocks.

Volatility = Panic?

Of course, a long-term preoccupation amongst students of the markets is not just how to take advantage of herding-fuelled market panics but how to predict them, because it's rather nice to be prepared ahead of time. Generally, though, it turns out to be quite difficult to do so: largely because all the sensible indicators like whether economies are actually doing well or badly and whether companies are more or less profitable don’t always matter very much when markets go mad. Often it really does seem to be a matter of psychology rather than financial fundamentals.

However, a nice piece of research by Dion Harmon and colleagues entitled Predicting Economic Crises Using Measures of Collective Panics attempts to do exactly what it says on the label. Now, generally economists have studied volatility, the rate of change of stock price movements, as a way of investigating behaviour during market crashes. However, volatility doesn’t appear to predict crashes:

“Studies find that, on average, volatility increases following price declines, but do not show higher volatility is followed by price declines.”

Which is perfectly consistent with investors suddenly panicking when share prices drop across the board, and doing what every sensible person does when they find that their favourite brand of beer has been put on sale: going home and selling it as quickly as possible, before its price drops some more. Actually, of course, we do exactly the opposite with things we understand the value of like beer, but our illogical behaviour after stock prices fall is the reason volatility appears to increase after a market crash, but not before.

Mimicry in Markets

Instead the researchers speculate that there might be a different indicator that would cause this sort of behaviour: the sort of thing that causes people to try to eat soup with a fish knife. The idea is that when we’re uncertain about what to do we tend to copy others – to mimic them. So if we’re investing in conditions of high uncertainty and rare events – something like the US government being downgraded by the credit rating agencies, for instance – then we’ll look around to see what other people are doing.

This makes sense, up to a point, at a dinner party. Unfortunately, in the real economy when uncertainty rears its nasty head it’s quite likely that no one has a clue what’s going to happen next in general terms, and you’re going to end up with a lot of worried people angrily waving fish knives around, shouting at bemused waiters and covered in soup.

Synchronised Stocks

More or less, this is what the researchers found. In the lead up to market crashes stock price movements synchronise. Most of the time if we look at a representative list of stocks we’ll find some are going up and some are going down: generally these changes are a combination of changing fundamentals and changing perception. In the run up to a crash, however, we find that this relationship alters: because everyone is following everyone else’s lead virtually everything moves in the same direction. In fact, if you look closely at the rare exceptions you’ll probably find there’s some extremely strong piece of fundamental news affecting it.

As the researchers say:

“We show that the recent economic crisis and earlier large single-day panics were preceded by extended periods of high levels of market mimicry – direct evidence of uncertainty and nervousness, and of the comparatively weak influence of external news.”

Self-Organised Panics

They describe these panics as self-organised – generated by a combination of uncertainty and mimicry rather than by real news. Of course, when the news itself, such as it is, is contributing to the general uncertainty it would be no surprise to find this effect feeding upon itself. Note that this synchronisation process isn’t necessarily all in a downwards direction. It would quite common to find stocks suddenly all moving upwards at the same time in the middle of crisis, simply because of some piece of apparently good news causing a small outbreak of buying.

Generally we can say that investing during these periods of mass mimicry should be done carefully, since individual stock prices are likely to drift wildly away from anything we might consider to be fundamental value. Nonetheless, these are times where a clear head and a sensible focus on real company valuation metrics are likely to yield great returns assuming you have any money to invest.

It’s just important that while you so you ignore the soup drenched masses around you. They don’t have a clue about the proper etiquette for market panics.

(Of course the best defence against market madness is a proper appreciation of history. And, after reading this crazily interesting academic nonsense, you'd better have a plan for when shares fall ...)