Stock market crashes are social phenomena where external economic events combine with crowd behavior and psychology in a positive feedback loop where selling by some market participants drives more market participants to sell. Xavier Gabaix, a finance professor at New York University, has derived a crash-frequency formula that he believes captures a universal trait of all markets, not just equity markets or those in the U.S. According to that formula, the odds of a 12.8{bf6128eaee7daf804a40e739f155a69f2d5a72ca2bacccc9954495bcd60bdcac} crash in any given six-month period are 0.92{bf6128eaee7daf804a40e739f155a69f2d5a72ca2bacccc9954495bcd60bdcac}, almost as low as the actual frequency in the U.S. stock market over the last century.

These factors are unable to account for all of investors’ exaggeration of crash probabilities, however, since at no point did the average individual investor believe those probabilities to be lower than 13.5{bf6128eaee7daf804a40e739f155a69f2d5a72ca2bacccc9954495bcd60bdcac}—17 times higher than the probability based on historical frequencies alone.

Warren Buffett ‘s favorite indicator is the Market Cap …