In the history of the modern American stock market, the chance of an extreme one-day crash is about 1% in any give six month period. So why is everyone constantly terrified that it will happen?

If you blame the media... well, you’re kind of right. But we’re not here to assign blame. (Are we not all products of sin, at last?) We are here, rather, to delve into the broken, twisted, dysfunctional machine that is the human psyche: The Place Where It All Goes Wrong (our title).

For decades, the economist Robert Shiller has been regularly surveying investors on their thoughts. One thing he asks them to do is to estimate the probability of a catastrophic market crash in the next six months. As we pointed out, the historic probability of such an event, like the “Black Monday” crash of 1987, is about 1% in any given six months. But over the past 25 years of investor surveys, “the mean and median probability assessments of a one-day crash were 19% and 10%, respectively.”

This tells us investors are very “wrong,” in their predictions.

But why? Is it because even the most “sophisticated” financial titans are, like the rest of us, naturally stupid sheep easily misled by the latest hype-filled report on any trashy TV network or blog? Friends, we are sad to report that yes, this is the case. All the experts know nothing. A new research paper by Shiller and two other economists finds that disproportionate negative media coverage of financial markets has a disproportionately negative impact on the minds of investors leading to the sort of wacked-out terrified predictions that we see in Shiller’s surveys. Why? Because even people who allocate money for a living fall prey to the most basic psychological flaws of the world’s most dangerous animal—mankind.

We find evidence that investors use recent market performance to estimate probabilities about a crash. We also find that the press makes negative market returns relatively more salient and this is associated with individual investor probability assessments of a crash... Finally, we also find evidence consistent with an availability bias when examining the crash probabilities of investors who recently experienced exogenous rare events; in this case, moderate earthquakes.

“Availability bias” simply means that people use the freshest things on the tops of their minds to make broad judgments, even when doing so is statistically stupid. So people read a bad Wall Street Journal and internalize that fear like a bunch of god damn, I don’t know, dogs, being trained to fear things. Even people who experience earthquakes are susceptible to the psychological trick of subsequently believing that rare events like stock market crashes are more likely, despite the fact that the two things have little or no real correlation. Combine this with the fact that the tawdry, click-hungry news media tends to focus more on negative events than on positive or neutral ones, and you have a formula for an irrationally worried populace—high-paid men in pinstriped suits who are, at hear, little more than terrified children, as we all are deep down.

The human condition is that most humans are wrong and the rest of them are out to rip you off. Not us, though. We are your friends.

[The full paper. Photo of rational financial professionals making well-reasoned risk assessments: AP]