The Impact of the Coronavirus on Investment Decisions
Crises are typically influenced by bias, overconfidence, shortsightedness and faulty forecasting - and COVID-19 is no different. To make sound, rational choices amid the current pandemic, investors should take a reflective approach that avoids panic and overreaction.
Friday, June 19, 2020
By Nupur Pavan Bang and Anisha Sircar
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?
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.
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.
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.
“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.
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.
Nupur Pavan Bang (PhD) is associate director, Thomas Schmidheiny Centre for Family Enterprise, Indian School of Business. She can be reached at firstname.lastname@example.org.
Anisha Sircar is a writer with interests in politics and business.