A Crisis of Confidence

Self-fulfilling prophesy. You hear that term a lot regarding the stock market. It was coined by sociologist Robert K. Merton, father of economist and Nobel laureate Robert C. Merton, known for his work on options pricing models (Black-Scholes-Merton, anyone? Anyone? Bueller?). Of course, the idea of the self-fulfilling prophesy has been around for ages and is a popular plot device, from Oedipus and Macbeth to Star Wars and Harry Potter.  It’s a fascinating concept, whereby a prediction influences the behavior that indirectly leads to the fulfillment of the prediction. I was talking with some colleagues about the phenomenon as it relates to testing. A person can end up failing a test, not necessarily because they were unprepared, but because they were so worried about failing that their lack of confidence caused them to freak out and freeze up on exam day.

In fact, it’s lack of confidence in the economy that we’ve seen weighing on the stock market lately. Investors hear news of a possible Greek default and subsequent European financial crisis and they worry that it will cause a downturn in global markets. As a result, they sell their investments, which – guess what? – causes markets to go down! A self-fulfilling prophesy. Then, the news turns positive (a possible bailout of Spain) and markets rally as confidence improves and investors buy back in.

It’s interesting to watch the effect of human behavior on the markets, but it can make you downright seasick when you’re invested in the market and riding the waves of sociological phenomena.  I know we’ve said it a thousand times, but the best thing to do is sit tight. If you can resist the pull of the crowd, you can dampen its effect on markets in some infinitesimal way. More importantly, resisting the urge to time the markets has been shown to improve investment returns over the long run.

 

Sarah DerGarabedian, CFA

Director of Research

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