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Psychology moves markets
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October 12, 2001: 4:24 p.m. ET
Since Sept. 11, U.S. stocks have been driven primarily by emotion.
By Staff Writer Mark Gongloff
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NEW YORK (CNNmoney) - Stock market activity in the United States always has an element of psychology, but it usually reacts to mundane things like corporate news and the mysterious utterances of Federal Reserve Chairman Alan Greenspan.
That changed on Sept. 11.
Since the terror attacks in New York and Washington, D.C., that killed thousands of people and triggered what will likely be a long war on terrorism, some of the biggest moves in U.S. stocks have been driven by strong emotions.
"The market's reaction is purely psychological," said Dr. Richard Geist, instructor in the psychology department at Harvard Medical School and president of the Institute of Psychology and Investing.
On Sunday, for example, America and its allies began air strikes in Afghanistan, leading stocks to fall on Monday. The market rallied later in the week, when news from the Middle East pointed to a very successful military operation. On Friday, NBC confirmed an employee in New York City had been exposed to anthrax, and stocks fell again, minutes after the news became public.
There's no logical reason for stocks to sell when crises hit, experts say. In fact, the shocking nature of major events often makes rational thought more difficult.
"Whenever you get a traumatic event happening in society, you tend to see certain reactions to it, such as irritability, depression, confused thinking and sleep problems," Geist said. "In that context, rational decision-making becomes very difficult. People tend to begin to let their thought processes be guided by their anxieties."
Instead of focusing on the historical resiliency of the stock market and the economy, investors choose to focus on short-term problems.
"When people are frightened, they cut their time horizon dramatically," said David Dreman, co-founder of the Institute of Psychology and Markets and the chief investment officer of Dreman Value Management LLC. "Even advisors will say to sell because they see portfolios crumble and they fear people will have nothing left. It's really not rational, but it does happen."
In fact, after every major crisis in the past century -- including the bombing of Pearl Harbor, the Cuban missile crisis and the assassination of President John F. Kennedy -- the Dow Jones industrial average sold off sharply at first.
After 11 such crises, according to Dreman, the Dow rebounded and gained, on average, 33 percent in the next year and 52 percent two years later.
"That tends to point to overreaction," Dreman said.
The irony is that, when the market rebounds as it always does, those who sold while stocks were on the way down will likely lose out when stocks rebound.
"If you have a long-term view of the market, this is one of the best buying opportunities we'll see for years to come," Dr. Geist said. "If you don't believe that, take a look at any stock market chart showing the past 60 years. Severe market retreats, which make everybody so anxious, look like tiny blips in an upward-spiraling market." 
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