Human Nature Is Stocks’ Most Volatile Factor

Imagine that when the stock market opens on Monday, the Dow Jones industrial average begins to plummet, and by the end of the day loses 1,800 points--from 7847.03 at Friday’s close to about 6,050, for a 23% decline in all.

No big deal, right?

That’s what two-thirds of individual stock investors said in a recent poll by mutual fund firm American Century Investments. Asked what they’d do in the event of a Dow plunge of that magnitude, fully 66% of investors surveyed answered “nothing.”

Another 14% of those surveyed said they’d buy more stocks or stock mutual funds if the market fell that sharply. Only 13% said they might actually sell some of their stocks.

The occasion for the American Century survey, of course, is the 10-year anniversary of the 1987 market crash. On Oct. 19, 1987--a Monday--the worst one-day fall in U.S. market history occurred, as the Dow sank 508 points, or nearly 23%, from 2,246.74 the previous Friday to 1,738.74 at Monday’s close.

It was a calamity that rocked the world--and indeed, one that was repeated worldwide, as markets everywhere were hit by panic selling.

But today, whether the crash of ’87 has any relevance for most investors is highly questionable. By most estimates, somewhere between 80% and 90% of the money in the U.S. stock market has come in just since 1990. Much of that may have come from veteran investors, but even so, surveys show that of the four in 10 American adults who own stock today, half or more are new to the market since about 1990.

That means many investors haven’t experienced even so much as a 10% decline in the Dow index, let alone trauma on the scale of the 1987 event. Many of today’s investors simply haven’t been tested by meaningful market adversity.

But that also makes the sanguine survey response to the question about a modern-day market crash extremely suspect.

How would you know how you’d react to a one-day, 20%-plus market decline if you haven’t been there before? It’s easy to say you’d be calm. But anyone who owned stocks in October 1987 knows how psychologically agonizing it was, and for a long time afterward.

*

Let’s skip ahead for a moment and ask what is perhaps the more important question: Could a crash of that magnitude happen again?

The short answer is, absolutely. True, U.S. financial markets have installed “circuit breakers” since 1987 to slow any dramatic price free fall. At the New York Stock Exchange trading would be halted for half an hour if the Dow were to fall 350 points. On resumption of trading, if the Dow were to lose as much as 550 points, trading would be halted for an hour.

But once reopened, the market could conceivably then go into a new decline that would be limited only by the day’s closing bell.

That’s the “could.” What about the “would”--as in, why would U.S. stock prices begin a rapid downward spiral today?

Interest rates and inflation remain generally benign. The U.S. budget deficit is a shadow of its former self. Corporate profit growth, while probably slowing, still is positive overall. The U.S. competitive position in the world remains enviable. And the demographics of an aging population certainly augur well for purchases of financial assets in the long run.

In October 1987, by contrast, interest rates were rising, inflation was double the current pace, Uncle Sam was borrowing massively, and Japan, not the United States, was increasingly considered the economy to emulate.

Yet three things look much the same as in late 1987: First, stock prices have mushroomed over the previous three years. The Dow has soared 107% since year-end 1994. Between year-end 1984 and summer 1987, the Dow zoomed 125%.

Second, reflecting investors’ bullishness, stock prices are historically high relative to underlying earnings. In fact, based on the earnings we already know about--that is, results for the 12 months ended June 30 (since third-quarter data are just now coming in)--the price-to-earnings ratio of the blue-chip Standard & Poor’s 500 index is over 23 today. By the same yardstick, on the Friday before the 1987 crash the S&P; P-E was about 20.

Third, and perhaps most important, there is no reason to believe that human nature has changed. Alter the mind-set of a crowd enough--with whatever new input--and you will surely produce a dramatic reaction.

The issue of herd mentality in the field of finance has become a hot topic in the academic world in recent years, as researchers focus on why people do what they do with their money. Even some “efficient market” adherents, who have long believed that stock prices at any given moment reflect the collective, informed, rational expectations of investors, have had second thoughts when faced with certain evidence presented by the behavioral-finance camp.

“I’m open-minded now [on the efficient-market theory],” admits Nicholas Barberis, assistant professor of finance at the University of Chicago, long a bastion of efficient-market believers.

Was the market efficient on Oct. 19, 1987, for instance? Ten years later, there still isn’t full agreement about what triggered the crash, or what it meant. Many analysts point to a combination of pressures: rising interest rates, trade disputes among Western allies, and proposed U.S. tax changes that would have limited corporate merger activity.

Once the crash was underway that Monday, what had been very popular “portfolio insurance” techniques used by institutional investors unquestionably worsened the decline. Many of those investors attempted to sell stock index futures contracts in Chicago to offset the losses they were seeing on their stocks in New York. What they didn’t count on was an ancient problem: In a panic, there’s no one to sell to. Hence, futures prices and stock prices, which are supposed to be in basic equilibrium, cascaded ever lower together.

Since then, the notion of fool-proof portfolio insurance has largely been disavowed, even though hedging still goes on, and the aggregate use of derivative securities like futures and options is greater than ever.

Larry Harris, professor of finance at USC, notes that a far more prevalent attitude among many institutional money managers (and individuals) today is not that they should protect their portfolios from a market decline but that they should stay indexed to the market, riding its ups and downs. In theory, “They don’t care if they go down, as long as everybody else goes down with them,” Harris notes.

But can the majority of indexed investors stay true to that discipline? If so, they would have no reason to join any selling spree that might begin, regardless of the cause.

*

Yet that’s where the behavioral-finance academic camp interjects a note of high caution. Many people who might otherwise find no rational reason to sell stocks may do so simply because they anticipate that others will sell.

Robert J. Shiller, professor of economics at Yale University, surveyed 3,250 individual and institutional investors in the days following the 1987 crash and garnered nearly 1,000 responses. What he found was that most investors cited little of importance in the way of news on Oct. 19 or over that weekend to account for their behavior either as buyers or sellers.

Rather, he found, many investors said they were reacting to “the price decline itself and the behavior of [other] investors reacting to it.”

In other words, Shiller says, the action many investors took on Oct. 19, 1987, was based not on a rational appraisal of market fundamentals or even on raw emotion, “but on their ideas about what was going to happen” to stock prices.

Moreover, even though most individual investors in fact did nothing on the day of the crash, their behavior was affected for a long time afterward. Stock mutual funds, for example, suffered net redemptions for 15 months after the crash--even though stock prices were steadily recovering.

What lesson should you take away from all of this? Not that another crash is probable. Historically, one-day crashes are extremely rare events. But in evaluating the percentage of assets you can comfortably hold in stocks, it’s wise to remember this: However likely it is that stocks will respond to the fundamentals in the long term, in the short term prices may depend far more than we’d like to admit on the vagaries of human intuition and the herd mentality.

(BEGIN TEXT OF INFOBOX / INFOGRAPHIC)

Then and Now

Where key economic and market indicators stood on Oct. 16, 1987 (the Friday before the market crash) and where they stand today.

*--*

Item Oct. 16, 1987 Now 3-month Treasury bill yield 6.89% 5.05% 30-year Treasury bond yield 10.18% 6.39% Dow Jones industrial avg. 2,246.74 7,847.03 Price-to-earnings ratio of Standard & Poor’s 500 index* 19.6 23.6 Dividend yield of Standard & Poor’s 500 index 3.1% 1.7% Consumer price index, previous 12-months’ rate 4.4% 2.2% Ounce of gold (Comex) $476.30 $324.30 Japanese yen per dollar 142.75 120.68 Stock mutual fund assets in billions $220 $2,228 Stock mutual fund assets as pctg. of U.S. market 7% 24% (Wilshire 5,000 index) U.S. budget deficit, previous fiscal year, in billions $150 $23**

*--*

* for 1987, based on actual earnings per share, four quarters through June 30 of that year; for 1997, based on actual operating earnings per share, four quarters through June 30 ** estimate Source: Bloomberg News; Times research