Fear Factor

It took 484 trading sessions for the sensex to climb from 10,000 (on February 6, 2006) and touch an all-time high of 21,207 (on January 8, 2008). It’s taken much less — just 191 sessions — for it to return to 10,000 and below. You may not know a thing about cricket, but you know about Sachin — and you may not know a thing about the stock market, but you know about the sensex. Till a few months ago, anyone — didn’t matter if he/she had any sense of the market — who suggested that the index would one day plumb four-digit levels was looked upon with a mixture of pity, disdain and ridicule. But that was before the world, as we knew it, changed forever. Just as there was an air of inevitability about Sachin hitting 12,000 runs, over the past couple of weeks, it’s been more a question of when rather than if before the sensex went 10,000-under.

What’s been going on in the stock market hardly fits canonical notions of rationality. In the last month or so, shares in Bank of America plunged to $26, rebounded to $38, plummeted to $20 and skidded back to $24 on Thursday. Evidently, people don’t have a clue of what Bank of America is worth. It’s hard to believe that stock prices are being driven by a rational assessment of value. Investors seem to be relying on the same primitive emotion that made our forebears bolt when approached by a hungry lion: fear. Of course, fear can be rational, as the experience with the lion suggests. But the dynamics of the financial mess suggests that investors, regulators and policymakers have been operating by gut-driven nostrums rather than hardheaded analysis of facts. The world is a complex place and we try to master it using simple rules. The problem is they’re often wrong, like the incorrect yet popular belief that past behaviour is a good guide to future performance. Unable to make quantitative judgments about risky propositions, we decide based on best and worst possible scenarios, regardless of their probabilities. That leads to decisions like going all in when the going is good and pulling out in panic when the tide turns. These quirks are magnified by our tendency to herd. We use other people’s behaviour to validate our own. There are such things as well-thought-out financial runs. The gyrations of the Bank of America stock might be caused by rational investors trying to puzzle out whether the bank will survive the crisis in good shape. Even the rise and fall of American housing finance could be spun as a tale of flawless logic: homeowners and banks bet on reasonable forecasts that home prices would continue to rise. When they didn’t, defaults rose and banks became insolvent. Other banks ceased lending to them. Investors sold bank shares. The End. I don’t think so, though. There is another psychological distortion to account for: our tendency to believe our own theory of the world. Consider former Fed chairman Alan Greenspan’s repeated insistence during the housing price run-up that there was nothing to fear. Greenspan lived by the belief that unfettered markets always lead to optimal outcomes. “Individual financial institutions have become less vulnerable to shocks from underlying risk factors,” he said in 2004. After the past few weeks, he might want to reconsider.