What impact might the present crisis have on investments?

24th March 2020

The present crisis will have impact on investments. There will be all sorts of financial and statistical modelling trying to figure that out – but we thought we might take a more psychological look at it.

In crises human decision making becomes focused primarily on maintaining rather than gaining. Stress and uncertainty make us give undue weighting to risk and loss and undervalue to potential and opportunity. Humans become convergent decision makers – they restrict the options they will consider and become far less psychologically open or flexible.

This is applicable to all humans – even scientists, medical professionals and financial experts.

So how might this impact present decisions about investment for both the business and individual consumer markets?

 

Decades of research into cognitive psychology and decision science have demonstrated that our decisions over money have as much to do with emotional and psychological issues such as fear, uncertainty, personal bias, regret aversion and ego as they do from the raw data we receive from the market.

Specific research has demonstrated that investors suffer just as much from decision bias as lay people. Factors such as memory, emotions, needs, perceptions, social acceptance, ego and experience can override factual data and evidence to influence decisions and behaviour in this space.

The present fall in investment stocks worldwide will no doubt see a psychologically underpinned reaction.

Let us take a look at how a few of these might predict the longer term impact on investment activity.

 

 

Fear of Losing Everything (FOLE)

One emotional bias that is probably going to have an undue influence at the present time is the Fear of Losing Everything (FOLE).

As we have established, humans become more focused on loss than gain in times of stress. When market volatility causes large downward swings in the stock market, people can become anxious, which can cause them to cut their losses and sell what they have remaining. This short term based decision (selling the remaining stock) is fuelled by emotional threat more than pragmatic stock assessment – and while might alleviate the short term stress – might actually produce greater threat in the long term. This behaviour was most notable in the fallout from the 2008 financial crisis. Investors pulled their money out of the stock market as a quick reaction to the market sell-off, only to subsequently miss out in the long term on recouping losses in the dramatic recovery.

 

 

Herd Psychology

Another factor that creates emotional responses is that of herd psychology. In times of uncertainty we follow what the majority do. Unfortunately, selling begets selling, which during a market correction may create a downward momentum on stocks that can be difficult to break. An ever downward spiral develops. This has a particularly strong influential impact on the confidence of inexperienced investors who look to the masses for guidance.

 

 

Bounded Rationality

The fact that humans have a Limited Attention Span can also lead us into making quick decisions.

Humans are constrained by what economist and psychologist Herbert Simon called, “bounded rationality.” This proposes that a human will make decisions based on the limited knowledge they can accumulate or they have access to. Instead of making the most efficient decision (which requires more effort and time), they’ll make the most satisfactory decision (based on availability of information or the level of noise about an issue). In other words the media, social media, peers etc. can have an undue impact on investors rational decisions.

Because of these limitations, investors tend to consider only stocks that come to their attention through websites, financial media, friends and family, or other sources outside of their own research. This influences them to swap and change their investments.

The very word investment gives everyone a clue of how it works and that it is a long term activity. Sometimes moving investments around even in times of immediate crises can actually work out negatively in the long term.

For example one study  analysed trades from 10,000 clients at a certain discount brokerage firm. The study wanted to ascertain if frequent trading led to higher returns. After backing out tax loss trades and others to meet liquidity needs, the study found that the purchased stocks underperformed the sold stocks by 5% over one year and 8.6% over two years. In other words, the more active the retail investor, the less money they make. This study was repeated numerous times in multiple markets and the results were always the same.

 

 

How to Avoid This Bias:

Recognise that the media has an effect on your trading activities. Learning to research and evaluate stocks will provide more accurate information for better decisions. Don’t let media noise impact your decisions. Instead, use the media as one data point among many.

Simply by pointing these bias’s out to clients and customers can make them rethink their decisions and strategy. Offering them transparent advice and support is key to gaining theory confidence and trust – even if that is to move their investments for the foreseeable future. They will appreciate your honesty and genuineness – and that will be something they will probably come back to in the future when things go back to some normality.

 

 

 

Author: Innovationbubble