The Pschology Of Investing: N Is For Negativity

Negativity Bias is a reference to our general predisposition to regard negative events as more salient and potent than equivalent positive ones. In particular it's associated with the idea of contamination - "a spoonful of tar can ruin a barrel of honey but a spoonful of honey does nothing for a barrel of tar".
 

Example

The psychologist Bruce Hood uses a sweater to demonstrate negativity bias. He can get anyone to wear his sweater - until he tells them that it used to belong to a serial killer. Whereupon no one will go near the thing despite the fact that, as far as we know, a woolly pullover is not a disease vector for serial-killer-itis.

In similar fashion investors pulled billions of dollars out of the market in 2008, just as it was starting its long crawl out of the abyss. People were much more focused on the damage further falls could do to their wealth than they were on the positive potential or, come to that, a more nuanced analysis of valuations or history. Negativity is psychologically contagious.

Causes

In evolutionary terms it's pretty obvious why we'd tend to favor the negative. If we're approached by two people, one of them a known friend and the other a stranger we'd be foolish to concentrate on the friend. We know they're not likely to kill us. Similarly we have an in-built negative reaction from food poisoning which puts us off the food we vomit up. Today, however, that food often isn't the cause of the illness but evolutionarily speaking avoiding it made sense. Eat berries, throw up, don't repeat.

Mitigation

You can't really help but be affected by negativity bias, and running for cover when markets go wrong is a natural reaction. Experience helps, but is an expensive teaching aid. Reading widely (try the Mlodinow and Fisher and (ahem) Richards books in the list linked below) can help, if you're willing to let the long-term trends of the past be your guide. After all, the person who forgets history is doomed to repeat it.