Herd mentality causes crashes

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If he were alive today, former Vice President Spiro T. Agnew would tell you in no uncertain terms how hard it is to keep the nattering nabobs of negativism down. He would warn you to be wary of the hopeless, hysterical hypochondriacs of history.

And he would be right.

Forget about the theory that the only difference between a stock price busting out or going bust is the difference between savvy, hard-working management and shiftless, self-serving misfits. Emotion influences stock prices, often times producing prices that do not reflect the level of talent in the executive suite or the fundamentals of the business.

On the way up, this irrational exuberance is all well and good as long as there is a ready inventory of fools willing to pay more than the last fool. When the supply of foolish buyers runs out, the issue becomes the supply of fools who want to sell for less than the last guy, which is where we find ourselves today.

Friday's 4 percent slide in the Dow Jones industrial average left the market barometer down 5 percent for the week, 27 percent since Sept. 1 and 37 percent for the year.

Daniel J. Howard, a marketing professor at Southern Methodist University, says investor behavior demonstrates the principle of social proof: The more an individual sees those around him believing something or acting a certain way, the more the individual believes that thing to be true or the behavior appropriate.

"Stock market bubbles and crashes are caused by herd mentality," Dr. Howard said. "It's scary to me because we make our own heaven, and we make our own hell."

The herd mentality is more fearful in a falling market, says George Loewenstein, a Carnegie Mellon University business professor who specializes in the emerging field of behavioral economics. That's because individuals start fearing the economic consequences of the market sell-off: whether they will have a job; whether they should reduce spending; whether they'll be able to make loan payments or get a loan to buy a car.

Those fears are evident in a CNN/Opinion Research Corp. poll released last week showing that 41 percent of Americans believe that a 1930s-style depression is somewhat or very likely over the next 12 months.

Dr. Howard expects those fears will put a dent in Christmas sales.

"It's going to be terrible," he said. "People are either uncertain or afraid. Those two moods ... do not bode well."

Dr. Loewenstein says research shows that when people are afraid, the world looks scarier to them. Those fears are compounded by the fact that people don't understand what caused the credit crisis and why its consequences are reverberating on Main Street.

"Part of the reason the market is so volatile now is that we're in unbelievably uncharted territory. No one seems to know what's going on," he said. "Even business people are having a hard time wrapping their minds around it."

This "monkey see, monkey do" behavior is evident in the outcome of market simulation experiments run by Penn State University economics professor Anthony Kwasnica. One involves a mock economy where participants make hiring and other decisions based on their economic outlook. Introducing an element of pessimism to their outlook makes participants start thinking that if everybody else is cutting back, they will too, Dr. Kwasnica says.

"It's self-fulfilling expectations," he said. "If I'm pessimistic and I think some of the firms around me won't be hiring a lot of people, I decide to be more conservative."

Of course, there's no way of knowing when a bubble will burst or when a bear market has run its course. In the technology stock bubble, many investors understood that a company that didn't make anything and had no immediate prospects to turn a profit shouldn't be selling at exorbitant prices, Dr. Loewenstein says.

"But they were buying on the prospect there would be a greater fool," he said. "It's much more difficult to know when prices are out of line on the downside.

"Everyone is desperate for experts to tell them whether they should be in the market or out of the market. There are no experts."

In the Great Depression, the wisdom of President Franklin Roosevelt's first inaugural address took a few years to sink in: "The only thing we have to fear is fear itself -- nameless, unreasoning, unjustified terror, which paralyzes needed efforts to convert retreat into advance."

Thus far, Warren Buffett's "I'm buying" pronouncement hasn't done the trick. That doesn't mean he's wrong.

"Now's the time to buy stocks, not later," said Dr. Howard.

But he does not expect the masses will do that until someone like Mr. Buffett leads the way. Then the masses will try to get rich by following, only to find "most of the riches have already been taken," Dr. Howard says.

The clear-headed Nobel Prize-winning CMU economists Dr. Loewenstein rubs elbows with every day also believe that it's time to buy. He likes their advice, but thinks it's too rational to act on just yet.

"They know what the right thing to do is, but they know it's too early," Dr. Loewenstein said.

Len Boselovic can be reached at lboselovic@post-gazette.com or 412-263-1941.


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