Seeing clearly through the red
Avoid herd mentality, urges behaviourist
In the esotericworld of behavioural economics, Monday’s stock market sell-off signalled that investors are firmly in the “red” zone.
According to the colour-coded spectrum of panic employed by the experts, it means the herd mentality has seized control of our collective senses, and the balance of decision-making is tipped overwhelmingly in favour of emotion rather than sober reasoning.
Traditionally, negative movements, whether they are on a company’s balance sheet or on a trader’s screen, are always coded in red. Positive movements, which have been in short supply of late, are coded in green.
What investors around the worldwere responding toMondaywas their perception of red.
“People are terrified,” said Lisa Kramer, associate professor of finance at Rotman School of Management at theUniversity of Toronto. “I see a lot of people reacting emotionally to the markets. Certainly there are things going on economically that are worrisome, but do they justify the kinds of movements that we’ve seen? I don’t think so; not at a fundamental level.”
OnMonday, amid hardly stunning predictions that Canada may be headed into recession along with the rest of theworld’s major economies, theTSX plunged 1,100 points in a midmorning anxiety-stricken sell-off, before it plateaued to end the day with a four per cent loss.
That behaviour mirrored similar alarm in theUnited States. All this on the first trading day after theU.S. government signed off on a $700-billion US rescue plan.
Forweeks, there has been a perfect storm gathering: less than optimistic economic news on the horizon, political uncertainty with major elections inNorth America, a credit squeeze amid unprecedented levels of debt, and a massive government bailout thatworked itsway throughU.S. Congress.
Add to that the “cascading” effect, for example, when commentators such as self-described financial guru JimCramer bellows out in a “dramatic statement” that investors should yank their money out of the stockmarket if they need it within the next five years. Cramer’s dire proclamation that stocks could lose 20 per cent of their value is directed at viewerswho may be among the casualties of theU.S. mortgage crisis, which is akin to pouring gasoline over a raging inferno.
In behaviourist lingo, this is called “awfulizing,” which means investors are gravitating toward theworst possible outcome by making short-term decisions that often have a self-prophesizing effect. ConsiderMonday’s nose dive after the recession predictions.
“When people get anxious about their finances, we don’t necessarilymake the most sensible choices under these circumstances,” explains Prof. Kramer.
And even though the history of stock markets is littered with booms and busts, human behaviour ensures that the herdmentality inevitably dominates.
After all, when a bunch of people are selling their stock, who wants to buck the trend and risk being the last person holding worthless paper?
If there is money to bemade, most peoplewant to be part of that joyride. Conversely, if there is money to be lost, no onewants to be around for that unpleasant experience.
For now, behavioural economics can explainwhy the herd instincts take over, but it cannot clarifywhy such sentiments change the course of events. The evolving science can measure the wild market fluctuations and even attempt to articulate the fear that is fuelling them. Yet there is no clear prescription forwhatwill make them stop or change course.
And though she understands more than mostwhat is behind the decisions, Prof. Kramer still responds emotionally very much like her shell-shocked investing brethren.
“My confidence is shaken,” she says, admitting that it has been painful to reviewthe damage done to her personal stock portfolio. Even so, she says, “Iwent againstmy emotional reaction.”
Put simply, the professor defied the trend to red andwent on a buying spreewhile the herd was going the otherway.
“I bought today. Prices are really cheap right now,” she said rather sheepishly. “I’m looking at it in the long-term.”
Lisa Kramer, associate professor of finance at the Rotman School of Management at the University of Toronto, says investors are unwisely reacting emotionally to the stock market changes.