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How 'animal spirits' move the market

By Elizabeth Landau
CNN
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(CNN) -- Rita Hritz knows several people who have lost more than $100,000 in the stock market recently, and she's not taking any chances.

Rita Hritz has pulled out of the stock market. Her husband, Jim Schaefer, won't retire as he had planned.

Rita Hritz has pulled out of the stock market. Her husband, Jim Schaefer, won't retire as he had planned.

She pulled out of the market in 2005 because she was tired of the ups and downs, and she has no plans to invest in anything again except real estate.

"I would like to invest in the future, but it's so volatile, I don't know that I would," said Hritz, 50, an ultrasound technician in Chardon, Ohio. Hritz submitted her story to CNN's iReport.com.

Hritz is just one example of an American who has lost confidence in the stock market, which has plummeted in recent months. Confidence among investors as a whole is a key factor in determining how the market behaves, economists say; when investors collectively lose confidence in the market, it is more likely to drop.

In fact, confidence is an example of an "animal spirit," a term referring to the psychological factors that move the market. British economist John Maynard Keynes coined the term.

"One of the reasons this recession was not foreseen was that people didn't perceive the role of animal spirit in how the economy works," said George Akerlof, winner of the 2001 Nobel Prize in economics and co-author of the new book "Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism."

Stories about the nature of the economy that pass from person to person are another reason why markets go up and down, he said.

The stories that friends tell one another or that are propagated through the media influence people's confidence in the market and therefore affect the market itself, he said.

For example, in the late 1990s, the "story" was that there was a dot-com bubble: People bought stocks in Internet and technology-related companies that seemed to be rising in value rapidly. When people realized that they'd been overconfident and that some of the stocks were overvalued, the bubble burst. Watch iReporters talk about their views of the economy »

"These stories get passed from one person to another, and because they get passed from one person to another, it acts like an epidemic," Akerlof said.

Markets also move because capitalism produces not only what people want but what people think they want, Akerlof said.

A person seeking to buy medicine in the 19th century might end up buying snake oil, a product without curative properties. Similarly, "snake oil" financial instruments are often sold in unregulated markets.

"We've just been through a period in which people have been buying assets on the basis that they were overconfident," he said. "They had too much trust."

It's only now that people are seeing that they had made poor investment choices, he said.

Where's the bottom?

Some people, like David Lowery, recently decided that they've had enough of losing money in the market. The 56-year-old truck driver in Euless, Texas, closed his IRA on Thursday. He had cut his 401(k) contribution from 7 percent to 1 percent of his paycheck Monday.

"What money you've got, better get it out and put it under the mattress," said Lowery, who also shared his views on iReport.com. Read his iReport

Lowery had hoped to retire in nine years, but now he thinks he may have to work until age 70. He may put his money in bonds or CDs instead of stock-based funds.

Some economists say you should take a good look at your job security before making investment decisions.

People who are facing layoffs or are unemployed should be more careful with their investments, but those with secure jobs can afford to take greater risks, said Lubos Pastor, professor of finance at the University of Chicago.

"People should not succumb to their fears. They should rationally assess whether they are able to bear the risk of the stock market," he said.

But while it's anyone's guess when the market will pick back up again, rest assured that it most likely will not hit zero.

"It's implausible that it would be zero unless we're hit by a comet or the government nationalizes everything," Pastor said.

Expecting history to repeat

Experience with recessions also affects people's investment behavior, some economists say.

Hritz got laid off and went bankrupt in 1981, a year that saw a recession. Her previous financial struggle has made her more cautious about putting money in the market today, she said. Read her iReport

Her experience is consistent with research that shows people who lived through the Great Depression tend to be more cautious with their stock market allocations, but younger people who did not live through that recession are more optimistic.

That means that, after this current recession, everyone will be more cautious than before, Pastor said.

Those who do stay in the market will reap the benefits of any future rebound, Pastor said. In fact, the market will rally several months before the end of the recession, but those who sell everything will miss out on that.

"Going just by on your instincts by fear and by your confidence, that is usually misleading," he said. "That type of investing leads people to buy at the peak and sell at the bottom."

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As for Hritz, she maintains a cautious distance from the stock market. Her husband, Jim Schaefer, was originally going to retire this month, but he has no plans to stop working, she said.

"We're seeing a decline in value of the house we're in, but I'm not panicking like I would if I would have played the stock market," Hritz said.

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