October 15, 2008
Are fear and greed a result, rather than a cause, of gyrations in the stock market?
Posted by Mike Guttentag

We have all heard the folklore: share prices are largely determined by the constant struggle between fear and greed, bulls vs. bears, and so on.  These psychological explanations of dramatic stock price fluctuations become especially prevalent when markets behave in ways that seem to defy other logical explanations.

Before we chalk up market gyrations to fear versus greed, let’s ask a basic question regarding the purported association between fear, greed, and market gyrations: which way does the causation run?  Do volatile markets create fluctuations between fear and greed, or do the dynamics of fear and greed create more volatile markets?  Analysis of the October, 1987 crash suggests that, at least in some cases, basic economic forces, rather than emotional swings between fear and greed, cause dramatic fluctuations in stock prices.

In previous posts I described how the aggregate demand for equity securities (or risky assets generally) might be oddly shaped if a sufficient number of investors follow a portfolio insurance strategy. In such a scenario, investors can create a situation in which the aggregate demand curve for risky assets displays an upward slope, rather than the typical downward slope.  When this type of demand curve exists, a vicious cycle of price drops and declining demand can ensue.  The resulting instability in the price of risky assets is not driven by irrational “greed and fear” behavior, but rather by the dynamic movement between two different equilibrium prices.  This model shows that it need not be investor emotions which drive share prices up or down, even during extraordinary booms and busts.

There is, however, a deeper level at which the adage about fear and greed holds true, even in the scenario described above.  When a drop in share prices is solely a consequence of an upward sloping aggregate demand curve for risky assets (as described above), important differences exist between the marginal investor’s attitudes toward risk before and after the price drop.  At the higher equilibrium price, more investors will hold risky assets and the average risk premium associated with an investment in risky assets will be lower.  A lower average risk premium could plausibly be interpreted as a higher level of greed.  Conversely, at the lower value equilibrium price, fewer investors will hold risky assets.  In this case, the average risk premium will be higher, which could be interpreted as a higher level of fear.  It is important to note that there is no change in individual attitudes toward risk (as would be implied by the fear and greed story), despite these changes in average risk premia.

This discussion of fear and greed helps to illuminate some of the implications of explaining a market crash in terms of an upward-sloping aggregate demand curve for risky assets.  In the next post, I will consider how a thoughtful regulator could have responded to the October, 1987 crash by taking into account the underlying dynamics that led to the crash. 

For those who are technically inclined, a more robust analysis of the effects of portfolio insurance, which reaches similar conclusions, can be found in Sanford Grossman & Zhongquan Zhou, “Equilibrium Analysis of Portfolio Insurance,” Journal of Finance Vol. 51, Issue 4, page 1379 (September, 1996).

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