The psychology of investors

THE sharp one-day drop in China's stock market on Feb 27 this year apparently had an enduring negative effect on major bourses worldwide. By the time the Shanghai exchange closed that Tuesday, its Composite Index had fallen 8.8 per cent for the day - the biggest one-day fall in China in 10 years.

A cascade of falls in other countries immediately followed. In Singapore, the Straits Times Index was down 2.3 per cent when the market closed. Bombay's Sensex 30 fell by 1.3 per cent. In Moscow, the RTSI index was down by 3.3 per cent. In London, the FTSE 100 was off by 2.3 per cent. In Sao Paolo, the Bovespa index fell 6.6 per cent and, in New York, the Dow Jones Industrial Average was down by 3.3 per cent.

These were significant falls - larger one-day drops in the Dow, for example, have occurred only 35 times since January 1950, or about once every 20 months. And two weeks later, all these markets outside China were down from 4.3 per cent to 7.8 per cent compared to their close on Feb 26.

This large and enduring effect surprised many, since the 'story' about the Chinese drop - that the trigger was a rumour that Beijing, concerned about speculation, planned to impose controls on the stock market - seems to have no logical relevance elsewhere.

If history is any guide, markets can be severely destabilised by one-day drops, which make powerful stories that have more psychological salience to investors than much larger drops that occur over longer time intervals.

For example, people were really agitated when the Dow fell 3.8 per cent on Dec 6, 1928, nearly a year before the famous 13.5 per cent crash on Monday, Oct 29. Now, of course, no one remembers that one-day slide in 1928, but, from the participants' perspective, it was an enormous event. Newspapers the next day described it as 'one of the severest declines the market has ever gone through', and 'the worst money scare since July 1, 1920'.

No news story that day discussed economic fundamentals or gave a clear sign of the cause of the decline.

But the Dec 6, 1928, event was the first in a sequence of increasingly severe one-day drops in the Dow over the course of a year. Despite a generally rising market, the Dow fell by 3.6 per cent on Feb 7, 1929, 4.1 per cent on March 25, 4.2 per cent on May 22, 4 per cent on May 27 and Aug 9, 4.2 per cent on Oct 3 and 6.3 per cent on Oct 23, before the infamous 'Black Monday' crash.

On each occasion, newspaper accounts further established the 1929 market psychology. The story was always that speculation had government leaders worried, which is, of course, essentially the same story that we heard from China on Feb 27.

The historical parallels go on. On Sept 11, 1986, the Dow fell 4.6 per cent, the steepest one-day drop since May 28, 1962. The next day, it fell by a further 1.9 per cent, and then, over succeeding months, by several sharp one-day drops that were precursors to the 22.6 per cent collapse on Oct 19, 1987 - the largest-ever one-day correction.

At the time of the Sept 11-12, 1986, event, I thought very hard about what could have caused it. I sent a short questionnaire to 175 institutional investors and 125 individual investors in the United States. I asked: 'Can you remember any reason to buy or sell that you thought about on those days?' The response rate was 38 per cent, and no reason was repeated by more than three respondents, except the stock market drop itself.

This, and a more elaborate questionnaire that I sent out after the next 'Black Monday' crash on Oct 19, 1987, convinced me that nothing more sensible is occurring than just what newspapers describe: speculators, responding to changing market prices, and fearing further changes in the same direction, simply decide to bail out. The actual decision to do so often can wait until the next stimulus, that is, the next day that a big drop occurs - hence, the possibility of a sequence of large one-day declines.

The bright side is that one-day stock market declines occur more commonly as isolated events with no long-term repercussions. So investors must now hope that the latest episode will be forgotten - unless and until hope succumbs to market psychology.

The writer is Professor of Economics at Yale University, chief economist at MacroMarkets LLC, which he co-founded (see macromarkets.com), and author of Irrational Exuberance And The New Financial Order: Risk In The 21st Century.

Copyright: Project Syndicate.