A Stock Panic Shut-Off Valve

The long summer march of steady stock market losses and volatility has spooked even high-level financial experts. Most know little about crowd behavior, something that might help them understand and control mass panic selling--the dreaded specter that flickered briefly in late July when 41 million people with 401(k) retirement plans dumped $18 billion in stock market mutual funds.

Some financial gurus have now proclaimed a market bottom. But investor anxiety continues, a potential market destroyer created by gradual replacement of large, professionally managed collective pension plans with millions of individually managed retirement accounts.

Apparently it never occurred to the Wall Street wizards that cheerful visions of a new, democratized “investor class” might one day dissolve into a demoralized, market-mauling mob. Yet a recent NBC poll finds investors in a bleak mood: Only 11% of small investors are “very confident” of making money in the stock market.

The question of how to prevent herds of restive, do-it-yourself retirement investors from becoming a selling stampede demands thinking about new policies designed to preserve collective financial security.

Old images of angry mobs physically wreaking destruction on people or property need to be replaced by the concept of a “diffuse crowd,” one that is linked electronically by television, e-mail and the Web. In today’s turbocharged stock market, as “Dot.con” author John Cassidy has pointed out, the pace of information flow has dramatically accelerated while rational reflection-and-response time has often dropped to seconds.

These constraints on rational reflection feed a fundamental crowd process termed “contagion.”

The biological metaphor is entirely apt: Threatening or extreme situations foster uncritical psychological suggestibility and the rapid communication of not only thoughts but also emotions, especially via rumors--interpretations of events that are unverified but potentially true.

Rapid communication and action are reinforced when crowd members have similar ideas, traits, motives and interests--the classic “birds of a feather flock together” phenomenon.

Though it is a diverse groups that holds 401(k) plans, a disproportionate number of these investors are in two sociologically similar groups especially alarmed by stock market declines: the tens of millions of baby boomers contemplating retirement and millions more already retired.

Together, they constitute the core of the new market time bomb. In his well-known collective behavior model, UC Berkeley sociologist Neil Smelser contends that free-market, free-speech conditions nourish crowd behavior in situations where societal strain and discontent are mounting. These are obviously factors in today’s markets: Professionals and the public alike exchange overwhelming amounts of information as they try to figure out what’s going on lately--even asking each other if another 1929 is at hand.

During such periods of doubt and confusion, a “generalized belief” may gain currency as to what is causing these problems. Thus the current widespread explanation that crooked chief executive officers and the super-rich are exploiting and looting a rigged system.

Investor crowds have thus far reacted with increased, though measured, selling while demanding reforms.

The nightmare that flickered recently is one of mass selling descending into panic--a rush for the exits driven by the frantic calculation that “if I don’t sell first, others will.”

The official response must restore trust in the financial-political order. New punitive legislation and dramatic arrests of corporate offenders are insufficient. Bitterness and betrayal abound, and a major disaster, such as another highly destructive terrorist attack, probably would produce a market meltdown.

A bold but potentially highly effective strategy for preventing market panic might be to consider some sort of minimal, federally backed insurance for 401(k) accounts--similar to that provided bank accounts by the Federal Deposit Insurance Corp. Individuals might pay extra fees for 401(k) protection, and only relatively conservative stock-and-bond funds might be certified.

Such insurance would be tagged as an expensive expansion of big government. But the costs of some sort of minimal, federally backed insurance for 401(k) plans might be relatively small compared with a sudden, mass stock market exit--whether that panic strikes next year or 20 years from now, when 76 million retired baby boomers need the funds to buy their groceries.

*

Frederick R. Lynch is a government professor at Claremont McKenna College and author of “The Diversity Machine” (Transaction Paperbacks, 2001).