Why There Will Be More Flash Crashes

Because traders have suffered "post-traumatic stress disorder" from previous episodes and the trauma of these incidents creates a feeling of personal insecurity and emotional vulnerability which can results in a psychological negative feedback loop.

Via the WSJ:

A year after the "flash crash," some Wall Street traders are still suffering from a type of post-traumatic stress that one psychologist calls "the flash-crash flashback."

"Your heart pounds, you sweat," said Ross Greenspan, a 25-year-old trader on the floor of the Chicago Mercantile Exchange. "You can get sort of a tunnel vision…you're looking at the screen, and you can't see anything in your periphery."

The young Mr. Greenspan is, of course, putting the cart before the horse, because it is the inability of most traders and market participants to utilize any kind of peripheral vision in the first place which affords them an opportunity to recklessly and single-mindedly take risks they aren't aware they are taking.

The feelings of panic that surfaced after the flash crash caused Mr. Greenspan to temporarily walk away from trading stock futures. He felt rattled during big stock-market gyrations, like the volatility seen following the Japanese earthquake in mid-March. It reminded him of May 6, 2010, when the Dow Jones Industrial Average plunged nearly 1,000 points and wiped out nearly $1 trillion of stock-market value in just minutes.

The strategic thinking of most market participants is diseased. Few have any sound, logical theory for engaging in the trades and investments they involve themselves with on a daily basis. They're so obsessed with the false idol of "empiricism" that they're convinced everything that has happened in the past will undoubtedly occur again in the future. In some instances they're correct, as their anxiety warps their decision-making and causes them to make their own fateful bed and then lie in it, such as with flash crashes.

The reality is, markets don't crash because history repeats itself-- history repeats itself because most people are ignorant of its lessons and choose the intellectually lazy way through life, playing the greater fool game and chasing momentum rather than doing the hard work of thinking critically about an investment thesis and digging through security filings and related data to find real value.

"Every little tick that goes against them feels like a personal assault on them and their ego…every little tick in their favor gives them a sense of hope and relief," Mr. Menaker said. "If you're experiencing a trade tick by tick, there's a lot of emotional volatility."

No real understanding of value, no real confidence in one's decision-making. This mindset guarantees volatility and upsets because your decision is only as good as the market says it is, second-by-second. Contrast that with an individual who has done his homework and identified $1 selling for fifty or sixty cents-- his margin of safety allows him some breathing room and he's consequently a lot less worried about how "popular" his decision is on a daily basis.

Searching out real value in the market is akin to cultivating authentic self-esteem via introspection and self-knowing.

"It's about dealing with the stress, dealing with the frustration, dealing with the fear," Ms. Shull said. "The fallacy of Wall Street is that we do it all quantitatively. Research shows you have to have emotions to make a decision."

Ms. Shull, an anxiety therapist hired by Wall Street, is obviously not in a position to be of much help. Emotions are the psychological reactions to the choices we make reflected against the values we hold. They don't help us make decisions, they come about in response to the decisions we've made.

What we've got here is a group of self-doubting, anxious, rudderless "empiricist" market participants being cared for by psychologists who have theory, but their theory is totally flawed and therefore unhelpful to the point of being harmful.

Essentially, it's like the guy responsible for hitting the "LAUNCH NUCLEAR WAR" button, standing over it, sweating, his stomach swirling while his psychologist friend says, "Well, do you feel like pushing the button?" Are you kidding? Of course he feels like pushing that button! Doing so would be the only way to achieve a definitive moment and relieve himself of his pent-up anxiety about all the close calls with nuclear war in the past.