Investor nerves have been jangling since Covid-19 infected the stock market. Some strategists say a vicious bear market is ahead, while others argue that investors have overreacted, divergent opinions mirrored in the confused market reaction – after suffering their worst week since the financial crisis, stocks subsequently enjoyed their biggest one-day gain in 11 years.
Behavioural finance experts will tell you that keeping your cool is never easy during any market correction but today’s environment is particularly emotional and uncertain. Here are three behavioural biases all investors need to be aware of in the current climate.
Intolerance of uncertainty
Financial commentators habitually trot out the old cliche that markets hate uncertainty, and there's certainly no shortage of that right now. How far will the infection spread? How long will it last? How will consumers and workers react? If draconian containment measures are enacted, how much economic damage is likely? History provides few clues. "This is kind of a new thing," as Nobel economist Robert Shiller has noted. "It's too much to ask for the market to get it right." Shiller's uncertainty is echoed by New York-based Tanaka Capital, which says we "don't know what the limits are and we don't know where it's going to peak".
All this uncertainty has the potential to unnerve investors. In fact, according to a 2016 University College London (UCL) study, people may prefer to know for sure that an outcome will be bad rather than wondering what will happen. The study found that having a 50 per cent chance of getting an electric shock was more stressful than knowing for sure that you would be shocked. “It turns out that it’s much worse not knowing you are going to get a shock than knowing you definitely will or won’t,” said Archy de Berker from UCL’s Institute of Neurology. “We saw exactly the same effects in our physiological measures – people sweat more and their pupils get bigger when they are more uncertain.”
The most stressful scenario “is when you really don’t know”, said study co-author Dr Robb Rutledge. “It’s the uncertainty that makes us anxious. The same is likely to apply in many familiar situations, whether it’s waiting for medical results or information on train delays.”
As already mentioned, opinions are divided as to the implications of Covid-19 for financial markets. UBS, for example, does not see "significant financial system distress", saying "many of the conditions that can allow for a rapid recovery are in place". On the other hand, Scott Minerd of Guggenheim Partners has described the coronavirus as "possibly the worst thing I've ever seen in my career" – quite the claim, given his career spans both the global financial crisis in 2008 and Black Monday in October 1987, when the S&P 500 fell 20 per cent (the biggest one-day fall in history).
How do people respond to conflicting information, when one person says risks are low, and the other says risks are high? People have an alarmist bias, says American economist Kip Viscusi, and consequently “devote excessive attention to the worst-case scenarios”. In a 1997 study, Alarmist Decisions with Divergent Risk Information, Viscusi asked participants to rate the risk of cancer from airborne pollutants, with each participant shown conflicting expert reports. One group of people, for example, read reports where government and industry experts were in disagreement, while another group were shown reports where two industry studies disagreed as to whether the risk was high or low. Instead of taking a balanced approach, people tended to discard the low-risk judgment and to place more weight on the high-risk assessment; that is, they tended to gravitate towards the more alarming account.
This alarmist bias may be even more evident in real-life cases, Viscusi cautions, as the media and advocacy groups often highlight worst-case scenarios. It’s reasonable to assume this alarmist bias also plays out in other informational contexts, he adds, including the “prospects of the stock market”.
Anyone who has lived through a bear market knows market declines can be scary, but the current environment has the potential to be especially unnerving, in that it's both a global growth scare and a global health emergency. "When strong emotions are triggered by a risk," says legal and behavioural expert Cass Sunstein, "people show a remarkable tendency to neglect a small probability that the risk will actually come to fruition."
In his essay Probability Neglect, Sunstein cites many examples of this unfortunate tendency. In one study, a group of people were asked how much they would pay to avoid a 1 per cent chance of a short, painful but not dangerous electric shock; another group were asked how much they would pay to avoid a 99 per cent chance of getting shocked. Now, there is a huge difference between a 1 per cent chance and a 99 per cent chance, but this difference was not reflected in participants’ answers. To avoid a tiny 1 per cent chance of being shocked, the median amount offered was $7; to avoid a 99 per cent chance (a near certainty), the median amount offered was only slightly higher, at $10. This probability neglect was not found in another experiment conducted by the same researchers, the difference being that the emotional stakes were lower in the latter instance. In other words, when you’re worrying about something that triggers strong negative emotions, your rational mind gets swamped by your emotional mind. As Sunstein puts it, “intense emotions drive out concern about probability”.
In another study, Sunstein asked participants how much they would pay to avoid a cancer risk of one in 100,000 and how much they would pay to avoid a cancer risk of one in a million. Here, participants showed some grasp of probability – on average, they said they would pay four times as much money to avoid the one-in-100,000 risk as they would to avoid the one-in-a-million shot. In a second experiment, however, the cancer was described in vividly emotional terms, as “very gruesome and intensely painful, as the cancer eats away at the internal organs of the body”. This emotional language swamped any considerations about probability; people were as willing to pay as much money to avoid the one-in-100,000 risk as they were to avoid the one-in-a-million risk.
Various other studies confirm this point. For example, Sunstein refers to research showing that when people are asked how much they will pay for flight insurance for losses resulting from terrorism, they will pay more than if they are asked how much they will pay for flight insurance from all causes. “The word ‘terrorism’ evokes vivid images of disaster,” says Sunstein, “thus crowding out probability judgments.”
In the early stages of the coronavirus-related sell-off, Ritholtz Wealth Management's Michael Batnick suggested investors who were feeling extremely nervous may have been taking too much risk, while investors who weren't feeling anything could probably afford to take more of it. However, there is an alternative explanation, namely that the nervous investors have simply been paying more attention to the headlines – not a good idea, given that today's uncertain environment is tailor-made for catastrophising.