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An Emotional Explanation For Stock Market Selloffs

Getty/Frazer Harrison

The is much disquiet that the market sell off in the US overnight doesn’t appear to have a catalyst. Clearly this is a response to our emotional need to know the “why” so that we can understand and contextualise the consequences.

But the answer it seems lies less in an obvious catalyst but in an understanding of behavioural finance and how it drives markets because as much as economists like to think of markets as Mr Spock, with a Vulcan logician’s ways the reality is often very different.

Indeed the complex ecosystem of the financial markets, even after the rise of high frequency trading and other computerised investment methods, is still just a sum of the hopes and fears of the traders and investors. Because markets are made up of many irrational humans they are less like Spock and more like Star Trek’s somewhat eccentric engineer Scotty.

Taking this analogy further James Montier of Jeremy Grant’s investment firm GMO, writing in his book on behavioural finance, says:

This is the world of behavioural fiance, a world in which human emotions rule, logic has its place, but markets are moved as much by psychological factors as by information from corporate balance sheets.

Indeed perhaps Keynes, writing in his General Theory of Employment Interest and Money put this best with his analogy about trying to choose the the contestant who was not the prettiest but the one that a group of judges would judge the prettiest:

It is not a case of choosing those [faces] that, to the best of one’s judgment, are really the prettiest, nor even those that average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be.

This sums up modern day momentum investing beautifully.

So there you go – last nights sell off was a result simply of traders seeing sellers sell and selling themselves which feed on itself.

Whether it reverses just as quickly or feeds on itself only time will tell.

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