The mass buying of toilet rolls last week that led to some shops running out of them has something in common with the stock market sell-off. Both are examples of an important fact about social behaviour – that it is influenced, for both good and ill, not just by reality but by our beliefs about what other people believe.
From one point of view, stocking up on toilet roll makes no sense. The coronavirus does not affect that end of the anatomy and many of the same people buying toilet roll were not buying medicines that might relieve some of the symptoms of the virus. So what were they doing?
Anticipating others’ buying, that’s what. If you fear that other people will buy toilet roll and cause a shortage, you’ll want to buy beforehand. And doing so is a free hit, because toilet roll keeps for years. In this sense, it is wrong to speak of panic buying. Such buying is a rational anticipation of others’ behaviour. It is perfectly common for some behaviour to be individually rational, but collectively self-defeating: arms races and the tragedy of the commons are other examples.
A similar thing can happen in stock markets. Just as shoppers were anticipating that others would buy toilet roll, so shares can fall if some investors sell in the anticipation that others will do so. Whether such selling is justified or not by the fundamentals is not always important. What matters are beliefs about others beliefs.
It’s not just anticipations of others’ selling that can cause us to sell. So too can actual selling. Back in 2015 Alan Moreira and Tyler Muir showed that higher volatility did not lead to higher returns, which meant that investors could achieve better risk-adjusted returns by holding fewer shares when volatility is high. Their research inspired the growth of 'risk-parity' trading algorithms – selling shares when volatility rises, which causes falling prices to lead to further falls.
Selling because others are selling can sometimes be sensible. It is impossible for any of us to know everything about a complex world and therefore reasonable to take cues from what others are doing. If you are in an unfamiliar town and you see one restaurant empty and another busy you might well infer that the latter is the better eaterie.
And, in fact, as Cornell University’s Robert Frank shows in his new book, Under the Influence, this is just what we do. We are influenced by those around us. This is true of our investment decisions. The University of Bergen’s Hans Hvide has shown that people’s stock selections are influenced by those of their co-workers, and Ben Jacobsen at TIAS business school in Tilburg has found that our asset allocations are shaped by those of our friends.
Just because behaviour is reasonable, however, does not make it always right. Brock Mendel and Andrei Shleifer have shown that one reason for the 2008 financial crisis was that traders bought too many credit derivatives because they thought that the other traders who were buying them knew what they were doing. But they didn’t. Traders were therefore “chasing noise” and so drove prices up too much. As Avinash Dixit and Barry Nalebuff wrote in The Art of Strategy, “equilibrium can easily be determined by whim or fad”.
In fact, it’s not just on complicated matters such as valuing credit derivatives that we can be misled by others. In some notorious experiments in 1951, Solomon Asch showed that even on a simple task such as telling whether lines are the same length or not, three-quarters of people at least once copied other people’s obviously wrong answers.
This contributes to some important political developments. Duke University’s Timur Kuran has shown that tyrants stay in power because people believe that others support them when in fact they are merely too scared to speak up. When their silence breaks, however, it unleashes a cascade of opposition and the overthrow of the tyrant. We saw this with the fall of Nicolae Ceaușescu, the Arab spring and the prosecution of Harvey Weinstein.
Such episodes tell us that social orders can be brittle. They can persist for ages, but suddenly collapse when people’s beliefs about beliefs change.
Which is what we are seeing in the stock market. The belief equilibrium that the FTSE 100 was reasonably valued at around 7500 has disappeared.
We don’t need to invoke mass irrationality to explain this. Klaus Adam and Albert Marcet have shown that even tiny deviations from full rationality can generate massive price swings.
Which gives us a reason for optimism. If beliefs about beliefs can change suddenly in one direction they can also do so in the other. Sadly, however, we have absolutely no way of knowing when this will happen or from what level. It is sometimes easier to explain events than to predict them.
