Reasonable Panic.(stock markets)

After last Tuesday's stock-market rout, which sent the Dow Jones average down more than four hundred points and erased more than half a trillion dollars of market value, Wall Street analysts and reporters quickly found a culprit: China. The Shanghai stock market had plummeted almost nine per cent before the U.S. market opened, supposedly raising concerns about the health of the Chinese economy and spooking U.S. investors. Other explanations were floated as well. Alan Greenspan had given a speech the day before warning of the possibility of recession. The government reported a sharp decline in durable-goods orders, suggesting that U.S. manufacturing was slowing down, and there were discouraging numbers from the housing market. All in all, it was a day with its fair share of bad news. At first glance, however, it didn't seem like bad news that was worth half a trillion dollars. So was the whole thing just a temporary fit of hypochondria? Did investors sniffle a few times and then all decide they were coming down with avian flu?

Some of the decline can certainly be attributed to some less than rational investor behavior. The slump in the Shanghai stock market, for instance, while precipitous, was, from the perspective of the U.S. economy, a non-event. For all the talk about the integration of global markets, there is very little foreign money invested in the Shanghai Stock Exchange, thanks to government regulations. Furthermore, the Shanghai sell-off appears to have been driven not by doubts about the well-being of China's economy but by local anxieties about possible new measures designed to curb speculation--something that would make no difference to American corporations. But the sell-off dominated pre-market news on Tuesday, and so investors were effectively given the message that China's problems really were America's.

This caused problems, because, as economists have found, investors often overvalue new information, particularly when it's presented in dramatic fashion. In one famous experiment by the psychologist Paul Andreassen, investors who selected a portfolio of stocks and then saw nothing but the stocks' changing prices managed their portfolios significantly better than investors who were also given a stream of news about the companies they'd invested in. The reason, Andreassen suggested, was that the media's tendency to overplay stories led investors to place too much weight on news that turned out to be of only transient importance. This doesn't mean that investors should be kept in the dark--indeed, markets work best when parti-cipants are drawing information from many diverse sources--but when a single story like the Shanghai sell-off captures everyone's attention investors will often overreact. This effect is magnified by the prevalence of short-term and momentum trading in today's stock market. If an investor thinks a piece of news has a ...