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Crash test dummies

time key

By Joel Dresang

New research shows that individual investors vastly overestimate the probability of stock market crashes, in part because of what they see in the news.

Anticipating risks is important, but letting short-term incidents muddy long-term plans can be harmful. Often, what worries us today doesn’t even matter to the future plans we disrupt.

Think of what would have happened if you had sold all your stock over the British referendum to exit the European Union. As the markets tottered in initial uncertainty, the Standard & Poor’s 500 index lost 6.5% in the first two trading days after the June 23 vote. Since then, the S&P not only recovered that dip but hit new highs.

Exiting the market because of Brexit would have cost a net gain of 2.4% in two weeks.

We know from psychologists and behavioral economists that we tend to make decisions based on our recent, most dramatic impressions. So, if we see the markets sell off for a couple of sessions, we fear they’re heading for another 2008 collapse, which prompts us to want to get out.

News headlines fuel that overreaction. Partly because of coverage of negative events in the markets, the average individual expects a nearly 1-in-5 chance of a catastrophic decline in any six-month period, according to a recent working paper published by the National Bureau of Economic Research. The more conservative median expectation – which cancels out extreme estimates – was 1-in-10, based on 26 years of investor surveys.

However, historical data suggest that the real chance of a crash – akin to those of October 1929 or October 1987 – is more like 1-in-100.

The new study also found higher expectations of an epic stock plunge among investors who lived near recent earthquakes – underscoring how we can let seemingly unrelated events distort our judgment.

The researchers – including Nobel laureate Robert Shilling – noted that their study builds on years of findings from scholars in the United States and Europe showing “significant media influence on investor behavior and asset returns.”

One of the most profound lessons I learned coming to Landaas & Company after a career in daily journalism was the importance of long-term thinking.

The news media generally are not wired for the long term. Their demise and continued struggle as an industry is evidence of that.

How to follow the news
At my desk, I have a one-page consumer’s guide for following breaking news stories. Among the specific tips for stock market volatility:

  • Do not obsess over the Dow Jones Industrial Average. Neither it, nor the stock market as a whole, are barometers of the economy. The media use the Dow as a shorthand, but traders pay little attention to it.
  • Markets are volatile. One day’s activity – up or down – may seem dramatic, but has little significance and foretells nothing. The media will be breathless. You should be worrying about something else … like whether it will rain today.
  • Billions of shares of stock are traded every day. Attributing the day’s results to any single factor is ridiculous. In fact, there are millions of factors, and therefore no explanation.
  • Though “stocks going down” makes news, that doesn’t reflect broader reality. Look at historical trends. Over time, the equities market steadily goes up.
Source: On the Media

But just think of the media’s job: To regularly sell you on what’s going on, to get you to read or listen to or view new stories meant to inform, enlighten and entertain you, yes, but also to compel you to keep consuming more stories. Media outlets compete with one another for your attention, hoping that you become a habitual (even addicted) customer.

One of the knocks against the media is that they tend to be negative. Indeed, Shiller and company reviewed Wall Street Journal coverage to confirm a “negative bias” consistent with other research results.

Usually, the media make a bigger deal out of a market drop than a stock rally, which “may be a response to rational reader demand,” according to the report. But also, it better fits the definition of “news.” The markets are supposed to go up. If they do, that’s not news; if they don’t, it is.

Another factor is the ubiquity of news. I say I worked at a daily newspaper, but that misrepresents the nature of news nowadays.

Lifestyles of consumers and opportunities for advertisers have pushed a multimedia 24-hour breathless streaming of news.

When I covered the market crash in 1987, I was reporting at an afternoon newspaper in upstate New York that published five days a week. That paper since has been swallowed into its morning rival, which now reports around the clock through updates on its own websites as well as Twitter, Facebook, Pinterest, YouTube, LinkedIn and more.

The point is that the news media are exceedingly harder to avoid, and they have an undue negative influence on investors’ expectations, which could harm behavior.

Avoiding the media shouldn’t be the goal. Knowledge trumps ignorance. It’s what you do with information that makes the difference.

Psychologists call our tendency to make decisions based on examples we easily remember the “availability bias.” But we have the power to resist such impulses.

For instance, if market movements frighten you, and you feel compelled to sell stocks, stop and think of a time when fears proved unjustified and panicking made matters worse.

Don’t overreact to the news. Take a breath to consider whether to react at all. Think of the long-term perspective as well as the long-term consequences of any reaction you consider.

Research tells us that catastrophic market crashes aren’t as likely as investors believe. But we also know that past performance is not a reliable predictor of future results. We can be nearly certain that the market will continue cycling from good times to bad and back again. We shouldn’t take the upswings for granted; we should prepare for the downturns.

The key is long-term thinking. I pay attention to the news knowing that the latest buzz will be updated later and revised tomorrow and – as often happens – forgotten next week.

I take what I read and hear and view with a grain of salt. I consider the source. For the most surprising developments, I try to seek historical perspective. And, as the serenity prayer suggests, I react only after thinking about what difference it would make.

Joel Dresang is vice president-communications at Landaas & Company.

Learn more:
Stocks: Long-term, consistent returns, a Money Talk Video by Dave Sandstrom

Volatility: What investors should know, a Money Talk Video by Marc Amateis

Focus on fundamentals to face volatility, a Money Talk Video by Steve Giles

(initially posted July 28, 2016)

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