Neuroscience and an Explanation of the Stock Market Plunge

Years ago, a young man had the two halves of his brain disconnected in an attempt to stop seizures. It stopped the seizures but changed his brain in surprising ways. One side of his brain could perceive and act on visual input and the other, disconnected, side could verbalize, or rationalize. The two halves could no longer communicate directly.

Researchers were in front of his house in a trailer, doing experiments. They flashed up a sign to one eye. It read, "Get up and walk." He got up and walked. The researchers then asked him what he was doing. The side of his brain in charge of verbalizing, of explaining, did not see the sign, did not know why he had gotten up. And yet that side of the brain kicked into gear, providing an explanation. "I am going into the house to get a coke," he offered. The explanation was rational and he might even have believed it. But the explanation that followed his action had nothing to do with the catalyst for the action. In this we just might get some insight into stock market analysts.

Tuesday the stock markets fell. A lot. By the time the dust had settled, the market had fallen more than any day since 9-11. Again this morning, the market is headed down.

What I find fascinating is how matter-of-factly analysts "explain" this plunge. One might have almost thought that they had predicted the drop, but of course they did not. "This is not surprising," I heard one analyst calmly say. "Sure," I thought. "And given you could so clearly see this coming you went short on the market on Monday and made millions. Right."

Simulation models can replicate the odd movements of the stock market. They can imitate the ups and downs, the steady upwards movement punctuated by sudden drops, the booms and busts. These simulations that reflect what are basically systems dynamics don't even need to have economic forecasts or reports fed into them. Which is to say that markets in which people speculate about how other people are speculating are subject to variability.

There are a few steady principles in the midst of predictably unpredictable movement. What do I mean by predictably unpredictable movement? If 300 million people are flipping coins, dropping out as soon as they get tails, there will actually be a very small number of people still playing after 1,000 coin flips. We can predict that this unpredictable thing will occur, even though we have no idea who in our initial group of 300 million will be so lucky. We can predict that the stock market will have very bad, no good, rotten days, even if we can't predict in advance which days those are.

The steady principles are this.

1. Risk and return are linked - if you want a higher return you accept more risk of not getting it.

2. People will flee out or flock to the market in response to what happened yesterday. Such people will generally do poorly, as such a reactive strategy suggests that they're continually buying high and selling low. Such actions will exacerbate movements - turning gains into booms and downturns into busts.

3. And finally, perhaps most importantly, financial markets are like banks; if people trust in them they perform well and if people are skittish about them, prone to pull out their money when worried, the markets perform poorly. Perhaps no social construct is so clearly a social construct, so clearly becoming what it is perceived to be. If a community has a great deal of faith in its financial markets and continues to invest in them, those markets will perform well (even though they'll be punctuated by the gyrations mentioned above). If a community loses faith in its financial markets and refuses to invest in them, those markets will perform poorly. Perception makes reality.

Next time you hear an analyst explaining market movement (e.g., "Profit taking shook Wall Street today as stocks fell 1.5%"), go ahead and laugh. Remember, we can't even explain our own actions.

Will Rogers' advice might still be best. “Don’t gamble! Buy some good stock and hold it till it goes up, then sell it. If it don’t go up, don’t buy it.”