Self-Induced Panic And The Financial Crisis

From the Physics arXiv blog:

Panicky behaviour can trigger stock market collapses. Now researchers say there could be a way of spotting it in advance

One idea in the world of finance is that the volatility of a market is a good measure of the risks it represents. So it's easy to imagine that volatility should also be a good predictor of financial crises, when the biggest corrections occur.

That's not the case, say Dion Harman at the New England Complex Systems Institute in Cambridge, MA, and a few buddies. They say that while volatility increases at the beginning of a crisis, it is unreliable as a leading indicator of trouble ahead.

Instead, they've found a better predictor of trouble--the presence of sheer, unadulterated panic.
That may sound like a truism but Harman and co say that the tell-tale signs of incipient panic are present well before crises become evident in other ways. And they say they have the evidence to prove it.
First, what is panic? In sociology, panic is defined as the collective flight from a real or imagined threat. So an important element is the way in which individuals copy each other. The critical transition that occurs during a panic is the change from behaviour that is stimulated from outside the group to behaviour that is triggered from within via large scale mimicry.

So one way of measuring the nervousness that precedes panic is to see how closely individuals are copying each other, say Harman and pals. To this end, they measured the fraction of stocks traded on the NYSE or Nasdaq that move in the same direction on particular day.

If these movements are the result of unrelated external stimuli then roughly the same number should move up as down. And sure enough the data from the year 2000 shows exactly this. At any given time in 2000, about half the stocks moved up and the other half moved down.

But throughout the naughties, this fraction changed substantially, say Harman and co. And in 2008, copying behaviour was so ubiquitous that the likelihood of any fraction of the market moving in the same direction was more or less the same. So it was just as likely that 80 per cent of the market would move up on a given day, as it was that 80 per cent would move down or that the split would be 50:50....MORE