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Dont Just Do Something...Stand There

Columnist

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David Raub
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In early October, participants in the securities markets found themselves in the middle of one of the most gut-wrenching experiences imaginable—a full-fledged panic. On the last Friday in September, after two tumultuous weeks that saw the bankruptcy of investment bank Lehman Bros., the failure of Washington Mutual and the near-failure of insurance giant AIG, accompanied by a complete seizure of the corporate credit markets, nervous market participants awaited details of a Treasury proposal to rescue failing financial institutions. That day, the S&P 500 Index stood more than 20 percent below its all-time high-water mark achieved in October 2007, meaning stocks were already in a bear market as that term is commonly accepted.

The U.S. House of Representatives took up the Treasury plan in emergency session over the last weekend in September and voted on the plan on Monday. To the shock of many, the House rejected it. The stock market quickly dropped another 7 percent from its October 2007 high. On Tuesday, cooler heads vowed the plan would come back for a revote with some modifications. The market gained back much of its losses the previous day.

But as October came, nothing seemed to assuage investors. Despite Senate approval of the Treasury plan on October 2 and the House revote and approval the next day, the market decline accelerated. Over the first eight trading days of October, the market dropped an astonishing 23 percent. The week of October 6 to 10 was the worst week ever for stocks. Shocked mutual fund holders and 401(k) participants rushed to sell their holdings as they watched their savings vanish.

In his 1978 book, Manias, Panics and Crashes, economist Charles Kindelberger (one of the architects of the Marshall Plan after World War II) reviewed the history of market crashes. Manias begin with excessive speculation in a market. As the mania grows, increasing numbers of investors seek to get in on the action, accompanied by excessive use of credit. Eventually, some event “pops the bubble,” at which point, investors rush for the exits in accelerating numbers.

The recent, rapid rise of housing prices fueled by subprime mortgages, followed by the collapse and panic in the markets that we’re now experiencing, has followed each of the steps outlined by Kindelberger 30 years ago. When the housing market began to cool in 2007, the market for the complex securities created to facilitate subprime lending began to fail. The meltdown in the subprime mortgage arena spread to other parts of the credit markets, leading to failures of important investment firms. These failures in turn caused the credit markets to seize up and now threaten to lead to a long and severe economic recession.

The final stage described by Kindelberger is a panic that feeds on itself until prices get so low investors finally become willing to buy risky assets. The first eight trading days of October certainly fit Kindelberger’s description of a panic. Whether the volatile trading the week of October 13 to 17 is a lull before further panic selling remains to be seen as I write this column. Only in hindsight will we know when prices got so low, investors stepped in to scoop up the bargains.

Why has the mania-panic-crash scenario outlined by Kindelberger happened time and again over human history? Important clues are coming to light in a newly developing field known as “neuroeconomics.” This new examination of human behavior arises out of studies in which brain activity of test subjects is mapped using MRI scans while they make decisions in game or investment scenarios. Apparently, different brain functions take place in different regions of the brain. What investigators have determined in recently published studies is that decision making in humans begins in the emotional centers of the brain.

In short, emotions lead to actions regardless of general intelligence or training. Other well-documented human phenomena compound the emotion-produces-actions framework of human behavior. One, known as “herding,” refers to the tendency of people to follow the crowd, just as members of a large school of fish all seem to change directions simultaneously, as if choreographed. Another phenomenon is called “recency,” or the tendency of humans to project recent trends to their extremes of infinity or zero (remember how in 1999, Internet stocks were going to go up forever?).

According to trader and formally trained neuroeconomist Denise Shull, investors confuse emotion with action, which are two separate brain functions. Emotions provide motivation: They make us feel we need to do something. Shull counsels investors to view emotion as information, which, she acknowledges, is hard to do, because the emotions in question are uncomfortable. Instead of acting on emotion, Shull suggests investors tolerate, then explore their emotions. This approach, she says, lets investors consider an expanded set of alternatives and gain a greater awareness of how biases affect the decision making process.

On Friday, October 17, the New York Times published an op-ed piece by Warren Buffett in which he commented that, when investors get greedy, he gets fearful, and when they get fearful, he gets greedy. Fear and greed are the primary emotions of Wall Street. I assume Mr. Buffett has never studied neuroeconomics, but it certainly sounds as though he applies the approach suggested by Shull.

Looking back several years from now, it’s likely that those who fled the stock market during the first eight days of October 2008 will regret their emotional response.