And Sometimes, We Freak Ourselves Out

There is an edition of Calvin and Hobbes called “Something Under The Bed Is Drooling” where they both imagined that there were monsters under the bed.

Source: Amazon

Sometimes, in the absence of any trigger factors, prices can still crash. Just like when Calvin and Hobbes were especially scared when the light was turned off for the night, in an environment of risk off, risk aversion and little information, investors are more prone to take the money off the table first and ask questions later.

Bubbles as the symptoms of over-optimism are mirrored by the reverse situation of over-pessimism and paranoia in the market. Fear is as valid an emotion as exuberance.

What can begin as an unsubstantiated rumour can quickly spiral into a sell-off. And as the sell-off gathers momentum, this is taken by investors as confirmation of the rumour.

In his book, “Manias, Panics and Crashes”, Charles Kindleberger noted that,

Liquidation sometimes is orderly but may degenerate into panic as the realization spreads that only a relatively few investors can sell while prices remain not far below their peak values. In the nineteenth century the word ‘revulsion’ was used to describe this behaviour.

Revulsion and discredit may lead to panic (or as the Germans put it, Torschlusspanik, ‘door-shut-panic’) as investors crowd to get through the door before it slams shut.

These are the opening sentences from Paul Slovic’s paper, “Perception of Risk”,

The ability to sense and avoid harmful environmental conditions is necessary for the survival of all living organisms. Survival is also aided by an ability to codify and learn from past experience. Humans have an additional capability that allows them to alter their environment as well as respond to it. This capacity both creates and reduces risk.

From the historical accounts of market crashes by Kindleberger and Slovic, to the most recent works by Richard Thaler, we are constantly reminded that the market can behave irrationally. Being a part of the market, it is not only useful to note how irrational one’s behaviour can be, but also to observe how irrational the market as a collective can be.

The problem with the market is that one moment it can don the cloak of rational homo economicus, and at another moment shed all clothings to reveal its naked Neanderthal origin driven by primal fear that has helped them survive since the early times. In addition, which signals bring about the behaviour as well as the timing of this is anyone’s guess.

While market prices usually follow a random walk, things change if a large enough collective in agreement impose their natural, human pattern-seeking tendencies, prices would no longer be random but form a bubble or a crash. China’s recent market gyrations are just the latest example in a long line of market booms and busts, probably exacerbated by the immaturity of the market participants.

There is still much to be explored in the field of behavioural finance, where finance meets psychology. Market participants who understand and are able to incorporate the findings into their model may have an edge over those who don’t.

After all that, I can’t help but ask – since when does being an investor, apart from understanding businesses and accounts, require one to be well-versed in psychology too?

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