When stock markets fall sharply and immediately recover, the losses seem to disappear. But that doesn’t mean no one feels any pain.
The Dow Jones Industrial Average (.DJI) fell 617 points, or 2.4%, on Monday—then promptly went up by an almost identical amount over the next three days. If you headed off for a hike in the wilderness on May 10 and came back on May 16, you might have concluded that nothing had happened: Over the full stretch of those four trading days, the Dow ended up just about where it started.
But big market moves, like flashbulbs that go off in your face, do blur your vision—whether investors realize it or not.
Robert Shiller, the Yale University economist who shared the Nobel Prize in economics in 2013 for his analysis of how human behavior shapes asset prices, has long tracked investors’ expectations of stock returns.
His Stock Market Confidence Indices are based on surveys now compiled monthly by the International Center for Finance at Yale. They show that investors are more likely to believe a market crash—on the scale of 1929 or 1987—is imminent in the coming sixth months if a recent sharp drop in stock prices was prominently covered in the media. The sharper the recent fall and the more prominent the news coverage, the more investors will tend to worry that a crash is coming.
That’s no less true among professional investors than it is among amateurs. “There’s a surprising similarity in understanding these things between individual and professional investors,” says Prof. Shiller. “The professionals may be better at reading balance sheets and income statements and the like, but not at evaluating whether this is 1929 all over again.”
One plausible explanation: In general, negative events sear themselves into the human mind more deeply than positive outcomes do. Mr. Market gets inside your head.
Over the millennia, evolution has sensitized humans to danger. “Imagine that you’re a caveman and saw a horrible mauling by a bear on a certain path,” says Prof. Shiller. “That will stick in your mind and you will tend to think, ‘I’m going to avoid that path even if the bear isn’t there anymore.’ A path with delicious fruit will also stick in your mind, but that’s not as important to your survival, so it’s not as memorable.”
That doesn’t mean every investor will sell in a panic. It does mean investors who have witnessed a recent sharp decline are more likely to fear another in the near future.
In a survey he conducted immediately after the Dow fell 23% on Oct. 19, 1987, Prof. Shiller asked investors what was most important to them in evaluating the prospects of the stock market. The crash in the Dow was much more important, they said, than major economic indicators, geopolitical events, or remarks by policy makers or financial commentators.
In March 2009, U.S. stocks had fallen nearly 40% in the previous 12 months. Still, more than four out of five institutional and individual investors thought there was a strong chance of another stock-market crash in the ensuing six months, according to the Yale survey. (They were wrong: U.S. stocks returned 32%.)
Many investors in Prof. Shiller’s 1987 survey reported “unusual symptoms of anxiety,” including sweaty palms or a racing heartbeat, during the crash that October. Among individual investors on Oct. 19, about 19% who bought stock—and 31% who sold—reported being anxious that day.
Roughly 45% of institutional investors who bought or sold shares on Oct. 19 experienced anxiety, the Shiller survey found. That’s presumably because they were paying closer attention to market news than individuals were.
What’s more, when stock prices make big moves, investors crave explanations. When the Dow swings by hundreds of points, especially downward, says Prof. Shiller, “people are looking at each other for ideas, and they look to the media for interpretations of numbers that could be meaningful.”
As soon as a reasonably plausible cause gets attached to a price swing, “narratives have a certain exogenous life of their own,” says Prof. Shiller. “It’s just contagious.”
Narratives don’t have to be logical to stick. The Dow dropped 617 points on Monday, according to market pundits, on the bad news that trade talks with China were taking too long. It rose almost as much over the following three days on the good news that the trade negotiations were still inching along.
Big price moves are much more common now, with the Dow around 26000, than they used to be. Since 1896, the Dow has fallen by at least 2% in a single day 1,011 times, according to Dow Jones Market Data. That’s once every 33 trading days on average. At today’s levels on the Dow, by historical standards alone, investors should expect stocks to fall by at least 520 points once every six weeks or so.
That will put big negative numbers squarely in view. And that, in turn, could help keep investors’ expectations from getting too far out of hand.
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