Selling begets stock selling as bears rule
By Kristin Roberts
NEW YORK, April 14 (Reuters) - Make a snowball and place it atop Mount Everest. Now push. By the time it reaches the bottom, it's an accumulation of size and speed powerful enough to wipe out a village.
The recent high-velocity tumble in U.S. stock prices has certainly not reached such a dramatic level yet, market analysts say. But as volatility rises and valuations fall, the risk of a profound pullback rises.
Steep drops in stock prices lasting for long periods of time are infectious, market and psychology experts say. Once a significant pullback begins, it will tend to accelerate, driving stocks lower and lower as more investors sell.
``It is group think,'' said Alan Newman, a technical analyst at H.D. Brous & Co.
``It's been like a gigantic game. I think in recent years investors have made their decisions based on what everyone else is doing. Everyone has followed one another into this belief in a new paradigm, a new economy,'' he said.
The Dow Jones industrial average (^DJI - news) fell more than 500 points on Friday. And the technology-driven Nasdaq composite index has lost more than 1,000 points this week. FOLLOWING THE LEADER
Group think, or the tendency of people to act in groups and follow the behaviour of others, plays a tremendous role in investment decisions, experts say. Once any dramatic move begins, investors will tend to either panic and sell or jump head-first and buy.
``It is certainly true that there is a large element of what we call momentum investing in stocks, just as in anything else -- music or clothing,'' said Michael Keenan, finance professor at New York University's Stern School of Business.
``That is one of the parts of the increased volatility we're seeing in the stock market. To the extent that everybody is doing that, it is making money for participants until the end of the game,'' Keenan said.
The larger the market move, the greater is the chance that individual investors will follow the trend that has already begun. Market veterans call this ``chasing the smart money.''
People don't behave rationally in these circumstances, says Kathleen Gurney, a psychologist and chief executive officer of the Financial Psychology Corp., which has studied financial behaviour by professional money managers and individual investors since 1986. DEER IN THE HEADLIGHTS
What's more, people freeze and sometimes panic, especially when they are heavily invested. The market is vulnerable to downdrafts because so many investors have entered unchartered territory, for which they have no preparation and no idea how to respond.
Their psychological experience in the stock market so far has been one of reward, which, in turn, has bred overconfidence.
``One of the most robust and famous psychological biases that people are subject to is overconfidence,'' said David Hirshleiser, finance professor at Fisher College of Business at Ohio State University. ``They picked a stock and it went up and that reinforced the view that they were smart stock pickers. They learned to overestimate their abilities.''
Now the market is being beaten back and the investor's world view is shaken.
``A large number of people don't know what to do, which causes a drop in liquidity,'' Hirshleiser said. "This can contribute to huge volatility in markets.
``We are getting to the point where expectations are out of line with reality, and negative surprises are going to force people to reevaluate,'' he said.
Indeed, volatility on Wall Street has reached unprecedented levels after record infusions of cash into stock markets. The collective force of individual investors has changed the nature of trading, spiking trading volumes on both the New York Stock Exchange and the Nasdaq market, and exaggerating market moves. BEAR IN THE HEADLINES
The technology-led rally that brought Nasdaq up 85.6 percent last year and through the 5,000 level in March made investors bold. But the markets turned, obeying the technical rules that Wall Street analysts had warned about throughout the incredible bull run up.
``We really have our own fantasies and a bull market just supports those fantasies,'' Gurney said.
``And we only come to grips with what we really are when the market goes down and stays down,'' she said. ``Clients don't understand what they emotionally can afford to lose until they have to reckon with it.''
One of Gurney's clients watched her portfolio's three-fold profits crumble over the past month.
``To make herself feel good, she bought herself a car -- a sports car, a BMW 745 black on black -- after zero gains,'' Gurney said. ______________________________________________________ Get Your Private, Free Email at http://www.hotmail.com