VIEWPOINTS : Rational Behavior Was One of the Big Losers in Stock Crash

If investors behaved rationally and acted as classic economic theory suggests they should have, the market crash of Oct. 19 never would have happened. Logic cautioned against bidding up the market to the 2,600 level, and even once that occurred, the most overvalued issues could have been sold without an across-the-board collapse.

But investors do not behave logically, they behave psychologically. The market is influenced as much by the peculiar human decision-making quirks among institutional and small investors as it is by the impersonal dynamics of supply and demand. A number of psychological principles illustrate what has happened in the market over the last few weeks and offer some clues about the immediate future.

Selective inattention, groupthink and bidding up the market.

The reasons behind the market’s spectacular gains in 1987 can only be comprehended by recognizing that people have a very limited capacity to deal with a mass of conflicting information. Consequently, they often draw on vivid personal experiences and the facts that are available off the tops of their heads when making decisions about risk. They tend to ignore abstractions and other information.

Over the past year, investors focused on the market reaching record highs and on the paper profits that they personally were accumulating. At the same time, they tried to forget problems that were just over the horizon, such as the national debt and trade deficit. Many investors were inspired to pay attention only to the good news about the economy as a result of the cheery optimism of Ronald Reagan, a man who could take an assassin’s bullet and still make jokes.

Unfortunately, when a group of people enjoys a string of successes, there is a tendency for the group to become overconfident, to insulate itself from unpleasant information and ultimately to make poor decisions. Psychologists use the term “groupthink” to describe this pattern of collective inattention, which seems to have been evident in military disasters, business failures and the space shuttle tragedy.

Investors did not completely ignore the problems in the American economy, of course, and many were tensely anticipating the end of the bull cycle. Yet no one really knew when Wall Street’s collective nerve would collapse, so information that was out of sight was largely pushed out of mind.

Emotional news, conformity and the October panic.

Why did the market collapse when it did? It will be years before we completely understand the October market, but one interpretation is based on the effect of a run of bad news on investor confidence during times of economic and political uncertainty. When the market is especially volatile, as it has been through most of 1987, investors tend to be overly sensitive to daily news events. Psychologist Stanley Schachter and his associates at Columbia University found that market-related news, including stock tips, have have a significant effect on trading during times of market instability but not during times of stability.

During an uncertain market, any news events that affect confidence in the presidency, and in the stability of the whole world, may influence investor decisions.

The Administration’s apparent incompetence during the Iran- contra debacle, the Bork nomination failure and a series of unhelpful statements by senior Administration officials dampened investors’ hopes for a clear solution from the White House for the nation’s economic problems.

Feelings of uncertainty were compounded by news stories indicating a threatening and uncontrollable world, which included the AIDS virus, the earthquake in Southern California, near-collisions on airliners, missiles striking U.S.-flagged tankers and Nancy Reagan’s cancer.

The world looked particularly dismal to many brokers in the first weeks of October because several Wall Street firms laid off hundreds of employees. There is nothing quite so demoralizing as friends who are out of work.

With all the bad news, even though much of it was not directly related to the market, many investors found themselves unable to sustain an optimistic outlook, and made an emotional decision to perform surgery on their portfolios.

Just as psychological factors created an irrational predisposition to sell among some investors, psychological dynamics were partially responsible for the depth and breadth of the Oct. 19 drop.

When people feel uncertain and confused, they look at what other people are doing and usually conform. Further, when a large number of people are in immediate contact, it is easier to become worried, and more difficult to remain calm and deal with complex new situations.

Together, these tendencies can produce hysteria and panic. Once trading volume started shooting through the roof, there was little to restrain the tide of emotion as it surged from the exchanges to the major brokerage houses to active investors across America and around the world.

Both seasoned investors and freshly minted MBAs responded to conformity pressure and panic rather than to carefully reasoned analysis.

Economic conditions made a market turndown inevitable, but emotional conditions contributed to its timing and its intensity. Computer program trading accelerated the market trend, but it was impulsive decisions by investors that turned greed into fear and created the stampede.

The condition of the stock market over the next six months will be influenced by concrete political decisions, by the temperament of both nervous and confident investors and by consumer buying patterns.

The 1987 bull market was sustained by mass denial of economic problems, but investors now require pragmatic political action to reduce the federal deficit, improve the nation’s balance of trade and stabilize interest rates to boost their confidence.

Meanwhile, big investors will be doing more homework before they buy, and they will be particularly attracted to issues that appear recession-resistant.

Consumers who have been laid off in the past, or who are in cyclical industries, may feel the need to conserve their limited capital and thus delay major purchases, contributing to an economic slowdown. Yet that scenario is not a certainty.

Good news can spur optimism, investor confidence and consumer self-indulgence the same way that bad news can produce pessimism and panic. And if federal officials take steps to inspire confidence, a new surge of vitality is likely to emerge in the market.