Market Fear

Have you ever wondered why the "velocity" of price drop usually far exceeds that of price gain? In other words, usually price drops much faster than price appreciation. I mean, aren't traders inherently greedy? Wouldn't they chase up what they seem to like, as much emotion as running in fear? To answer that question, we must probe at psychology of trades, in the field of behavioral finance.

There is a monumental paper titled Prospect Theory written by Daniel Kahneman and Amos Tversky from Princeton in 1979 describing human decision instead of optimal profit maximization utility theory. This paper has been quoted so much that it ranked second of all economic papers ever published. The first one was a statistical tools paper which presently have no additional value of what we have already known. So this Princeton paper can be regarded as the one of the most useful reference in finance and economics.

One of the key take-away from the paper is that people value loss much more than gain, despite equal magnitude in outcome. That is, the perceived loss in my mind for 10 bucks loss is far greater than perceived value of 10 bucks gain. And the reference point moves with one's wealth, so this greater perception of loss is present in most people regardless of the size of their wealth.

In addition, there is a tendency for people to overweight the small probability of loss, leading to a risk-averse attitude towards investment with small risk (probability of loss) and moderate reward.

Overweight of Small Probability of Loss

Notice that there is two discontinuities in the above graph, and that the perceived change of value is quite flat for a large range of probabilities in the middle. In other words, a winning chance of 40% is seemingly equivalent to 60% chance of profit in our mind, even though mathematically they are vastly different.

On the other hand people are also tend to overweight small probability of gain, leading to risk-seeking attitude towards investment with small probability of gain but moderate change of loss.

There is a third area in human psychology regarding risk and profit, and there exists several zones of comfort that is dependent on the size of one's portfolio or wealth, in which more risk is tolerable when the size of that bet is small regarding to the total size of one's wealth. This one is easy to understand, and I will not explain further.

Now let's come back to our original question. What happens when a trader see a group of sell orders showing up on exchange's quote feed? In his mind, a realization of things may go south occurs. Now we are in the region of "potential loss". Once the loss move past a trader's comfort zone (depending on the size of his trade, usually a small swing in prices will move past a day-trader's comfort zone because of the inherent large bet nature of day trading), panic will kick in very quickly. And the fear feeds on themselves as you may notice from the first graph above, that the drop of value falls rather quickly. This explains why price drop as a result of exodus sell would often be much deeper than any other euphoric rise of prices.