Thursday, March 20, 2008

Why stock markets tumbles...

Recently, stocks are sold heavily and price of stocks are coming down very fast. Everyone gets panic and coming out of market even though they are in loss to reduce further loss. This behavior was very well explained by Merton in his book Social Theory and Social Structure. He wrote a fictional story about a bank.

There was a bank of Cartwright Millingville. It is a typical bank, and Millingville has run it honestly and quite properly. As a result, like all banks, it has some liquid assets (cash), but most of its assets are invested in various ventures.

Then one day, a large number of customers come to the bank at once —the exact reason is never made clear. Customers, seeing so many people at the bank, begin to worry. False rumors spread that something is wrong with the bank and more customers rush to the bank to try to get some of their money out while they still can. The number of customers at the bank increases, as does their annoyance and excitement, which in turn fuels the false rumors of the bank's insolvency and upcoming bankruptcy, causing more customers to come and try to withdraw their money.

At the beginning of the day — the last one for Millingville's bank — the bank was not insolvent. But the rumor of insolvency caused a sudden demand of withdrawal of too many customers, which could not be answered, causing the bank to become insolvent and declare bankruptcy.

Merton concludes this example with the following analysis:

The parable tells us that public definitions of a situation (prophecies or predictions) become an integral part of the situation and thus affect subsequent developments, This is peculiar to human affairs. It is not found in the world of nature, untouched by human hands. Predictions of the return of Halley’s comet do not influence its orbit. But the rumored insolvency of Millingville’s bank did affect the actual outcome. The prophecy of collapse led to its own fulfillment.

There is lot of connectivity about the story of Millingville's bank and current stock market. Hope you agree with me.