Psychiatrist Richard Peterson, CEO of MarketPsych, a firm that applies behavioral science to financial markets, talked about last week's volatility:
Q: How do you explain all the turmoil?
A: It has to do with the flow of information. People often respond slowly. There's under-reaction where news hits the market and people don't respond right away. And there's overreaction. People collectively say, "Oh my goodness, it's terrible," and sell in a panic.
Q: The news usually doesn't lead people to take action. What does?
A: The key to what's happening here is how information flow affects human behavior. How you feel determines what you'll do.
The information people get from the media can influence their emotional state and change what they're likely to do.
Q: What's the most ridiculous analysis you've heard during this turbulence?
A: I think a lot of the explanations about China are ridiculous. It's when people pin it on an exact cause. To say it was China not stepping in to save the market on Monday, so of course they had to sell. It's just fishing for a reason.
Q: Is there a better explanation?
A: It's the accumulation of bad news from multiple places: from the oil sector, from the mining sector, from China. As bad news accumulates, it makes people gradually less likely to take risks.
The probability that a small decline will turn into a big decline increases. It's like a forest that hasn't had rain in a while. A few sparks fall on the undergrowth, and they don't start anything. But eventually, the tinder gets so dry, it becomes a conflagration.
Q: Is there anything like this in daily life? When people hear a fire alarm, they often sit still until other people get up.
A: In this case, people know they shouldn't pay attention to the ups and downs of the market. But what makes them pay attention and decide to collectively bail out? Does China really matter all that much? They're slowing down from 7 percent a year economic growth. Big deal. Falling oil prices are good for everybody.
So how does this get framed as a negative? In conditions of uncertainty, we tend to look to the herd to tell us whether it matters, and the best representation of the herd is prices.
People assume the herd has better information. The herd knows something they don't. So when the herd starts moving, you think, "I'm safe if I'm with the herd."
Q: You usually advise big investment funds. Any advice for the average Joe?
A: People have to decide if they're going to try and time the market or sit and hold on. If you're going to buy and hold, stop paying attention. Review once a month or once a year. You need to have discipline.
Q: Because if you're always paying attention, you make decisions based on the heat of the moment?
A: You wind up reacting. You want to make your decisions in advance. Reacting to the market's price action is probably the worst thing you can do. That's how you get whipsawed.