This
article was first published by the Global Association of Risk Professionals,
Risk Intelligence, on June 19, 2020; Co-author: Anisha Sircar; https://www.garp.org/#!/risk-intelligence/market/investment-management/a1Z1W000005VYeIUAW
As the world heads toward a
global recession, with plunging equity markets and countries facing severe
economic downturns, there are uncertainties and strong beliefs that have practically
divided the world into the optimists and the pessimists. There are those, for
example, who make rash, seemingly opportunistic investment decisions, and those
who are more measured in their financial approach. Those who unwittingly
indulge in herd behavior, and those who are less prone to such external
influences.
What's more, there are those
who are extremely cautious, favoring extended lockdowns and total isolation,
versus those who have a more “que sera, sera” approach to COVID-19, supporting
getting back to normal as early as possible.
It's easy for one group to
feel that the other group is being unreasonable. The pandemic's unprecedented
impact on our lives, both in the short and the long run, makes people highly
susceptible to making decisions they would have otherwise avoided.
In this article, we reflect
upon the financial and investment decisions being made by people in the
backdrop of the pandemic, and the dichotomy facing risk managers and investors.
What are the obstacles standing in the way of investors making rational
decisions and avoiding unnecessary risks in a time of crisis?
Bias
When analysts, policymakers,
“experts,” and/or news reports offer statements and opinions, it's sometimes
assumed that they know what they are talking about. However, people find
opinions credible as long as it confirms their own thoughts or anxieties, or as
long as they seem like “educated” or even consensus-based guesses. This can
involve a range of biases, from herding behavior, to action biases, to confirmation
biases.
When COVID-19 hit markets, it
resulted in phenomena such as dwindling risk appetite and investor interest and
declines in the perceived values of stocks. That led to dramatic drops in stock
prices, wiping out any potential investor gains.
Herding behavior is tricky
with respect to risk appetite and investing. It drives markets toward excesses
during market upturns and nose-dives during downturns. It's why stock indices
in India, the U.S. and Europe plunged, especially between mid-February and
mid-March this year, and why circuit-breakers were triggered several times in
recent months.
In India, the major indices
lost 40% in just two months. While it might be natural to get carried away with
all the noise and the herd, turbulent times like these call for more
reflection, rather than panic selling. Investors in countries like India have
been used to more euphoric highs over the last few years, and the losses on
investments therefore now seem particularly painful.
Markets in India spiraled
almost immediately into a “bull phase” in a fortnight, recovering 20% from the
bottom. However, it's important to keep in mind that, by and large, market
indices have rebounded and hit new highs after every previous global financial
crash. So, despite the noise, this may be the time for anxious decisions to hit
pause.
Shortsightedness
In 1995, Shlomo Benartz and
Richard Thaler conducted a study titled, “Myopic Loss Aversion and the Equity
Premium Puzzle.” The researchers asked: How much will the equilibrium equity
premium fall if the evaluation period (of a portfolio) increased? In other
words, is checking and re-checking your portfolio beneficial or detrimental to
how well it does?
Their research found that
more frequent checkers show considerably lower portfolio performance over time.
“In a sense,” they concluded, “5.1% is the price of excessive vigilance.”
Long-term profits can be found where there is courage to move away from the
crowd — and think long-term.
On the other hand, there are
those who did bottom hunting when the markets crashed and are now raking in the
moola.
In essence, investors who hit
the pause button (the que sera, sera group) felt that those who were
rebalancing their portfolios were being myopic; on the other hand, those who
were actively trying to buy and sell thought that the other group was simply
being “stupid.”
However, in the end, every
investment decision needs to incorporate the risk appetites and the risk-taking
capability of people. Someone may have a higher risk appetite – but if the
capability to absorb a huge loss is low, then wait-and-watch is perhaps a
better approach than investing in uncertain times.
Overconfidence
Psychologist Daniel Crosby
believes that uncertainty often leads to two kinds of behaviors —compensatory
over-confidence or worst-case scenario thinking, neither of which results in
smart financial choices.
While the volatility in
markets during the pandemic may be partly attributed to panic, investor
overreaction (which led to excessive trade volume) was certainly another cause.
This is reflected in how markets have periodically surged because of
overconfidence about the worst of the virus having passed.
Shortly after these surges,
indices are found plunging back down again. The phenomenon is also reflected in
how “experts” have been making a variety of assertions in the recent weeks,
guaranteeing that investors will be spared the pain that others may be
experiencing.
Overconfident people, write
researchers Mao Zhang and Yi-Ming Wang, “may perceive themselves more favorably
than others perceive them, or they may perceive themselves more favorably than
they perceive others. (…) It is common for most people to rank themselves as
better than the median.” Moreover, they note that it's also “common” for men to
trade more excessively than women, and for individual investors to show more
confidence than institutional investors.
This plays a significant role
in market volatilities, because overconfident investors are usually quick to buy
on margin ahead of a stock market crash. In the run-up to the Great Depression,
the “Roaring Twenties” saw a lot of overconfidence, and several investors used
large margin positions to leverage their beliefs. But this caused an asset
bubble, and when the depression hit, they lost everything they owned. Indeed,
they even owed large sums of money, ultimately leading to banks having to
declare bankruptcy — and everybody losing.
The takeaway? Avoid
overconfidence: think long and hard before buying on margin in uncertain times
if you don't have the appetite to stomach a huge loss.
Faulty Forecasts
“Experts” have made an array
of predictions, ranging from global economic agencies projecting India's
potential economic recovery to analysts saying the global economy will bounce
back in the next financial year. These forecasts assume that central banks will
cooperate and offer a way out, and that currently spooked investors will react
to the rescue and re-enter the market. But as we have seen in the past, people
can just as easily do the exact opposite, crisis or not.
In a pandemic, the seemingly
opposite behaviors of people get amplified. Everything starts to seem black and
white to people, but markets and behaviors actually remain grey and complex,
interacting with each other in intricate ways.
Parting Thoughts
Turbulence and downturns have
causes relating to behavioral and psychological factors that are difficult to
control and explain. But what's certain is that not allowing investment
decisions to be fueled by emotions and biases is a wise course of action. Now
more than ever, people need to get back to the basics: minimize costs, be
COVID-19-cautious, and resist the urge to time markets — and the virus.
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