Panic? What panic?

Another decent and unspectacular day on Wall Street. The Dow was up 42 points, with airlines, utilities and biotech issues doing especially well - but more importantly, no one, except maybe a couple of subprime lenders, on ther ropes. So here we are two weeks after the market's big drop and financial life goes on, reasonably clear of the panicky scenarios about the economy. The New Yorker's James Surowiecki reexamines the news during that terrible Tuesday and concludes, quite reasonably, that there wasn't much reason to get all hot and bothered in the first place.

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 participants 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 chance of causing a sell-off, he is likely to respond by selling, too, thereby feeding the frenzy he anticipated.

Surowiecki actually called the sell-off paradoxically reassuring.

Academics and policymakers have been arguing for a while now that investors are foolishly indifferent to the risks facing the global economy. But last week’s sell-off suggests that in the stock market, at least, investors are all too sensitive to the many things that can go wrong. The effects of last Tuesday may have been painful, but in the long run, this is probably good news. In a risky world, it’s better to have wary investors than reckless ones.