The Frontal Cortex

What a vivid example of human irrationality:

An erroneous headline that flashed across trading screens Monday, saying United had filed for a second bankruptcy, sent the airline's stock plummeting.

United Airlines shares fell to about $3 from more than $12 in less than an hour before trading was halted, wiping more than $1 billion in value. Its shares closed at $10.92, down 11.2 percent.

By the end of the day, fingers were pointing in many directions to assign blame.

The episode was a reminder of how negative news, rumors and even outdated articles can travel at lightning speed, with some investors selling before pausing to check facts.

Oh, herd behavior. I've always enjoyed the example of herd behavior used by Robert Schiller, because it neatly illustrates how we rely on our social instincts when confronted with uncertainty. Imagine two restaurants that open next door to each other. The first hungry customer doesn't know which restaurant is better, so he flips a coin and hopes for the best. A little bit later, another customer arrives. He also doesn't know which restaurant is better, but he assumes that the restaurant with at least one customer must be better. When the third customer shows up, he sees two people in one restaurant and none in the other, so he also goes to the popular place. The cycle continues in this manner, and most customers end up choosing the popular restaurant, even though the other restaurant might serve better food. We clearly find comfort in numbers, especially when feeling anxious.

This is known as an information cascade, although what's striking is how little information is actually being analyzed when making a decision about where to eat, or whether or not to sell United stock. Instead of thinking for ourselves, we rely on the judgment of others, who are also relying on the judgment of others, and so on. "The popular notion that the level of [stock] market prices is the outcome of a sort of vote by all investors about the true value of the market is just plain wrong," Shiller writes. "Hardly anybody is really voting. Instead people are choosing not to, as they see it, waste their time and effort in exercising their judgment about the market."