When markets crash our minds go haywire. For investors who don’t have a plan in place, this can be a dangerous time. Below are three key reasons why this happens and a link to suggestions of what to do in a sell-off.
(1) Hot head
During moments of extreme emotion, we act differently to how we expect. This even happens when the emotions are familiar.
A great example is set out in behavioural economics bestseller Predictably Irrational. The book’s author, behavioural psychologist Dan Ariely, and a colleague undertook an experiment which involved male university students filling in a questionnaire about their amorous, bedroom preferences and behaviours. The questions were first answered in a 'cold' state and then some weeks later in an impassioned 'hot' state.
To save readers’ blushes, I will not go into detail about how the 'hot' state was induced or why the academics thought it best to wrap in cling-film the laptop on which the questionnaire was answered the second time. However, the results from the experiment were very illuminating in regard to how human behaviour changes at moments of visceral excitement – such as when stocks plummet.
Indeed, what the participants thought were their preferences when in a 'cold' state, was very different from what their preferences actually turned out to be when they were in a 'hot' state (the state in which such choices are actually made). When 'hot', participants felt far more relaxed about the precautions they would take during a romantic foray (far more likely to make costly mistakes) and were far more adventurous in the activities they expressed a desire to experience (far more willing to take risks).
(2) Total despair
During extreme events, it becomes very hard to see beyond the here-and-now. Nobel prize winning behavioural economist Daniel Kahneman coined the term What You See Is All There Is (WYSIATI) to encapsulate the many behavioural traits that stop people thinking beyond a dominant narrative. Many of these traits were identified by himself and long-time collaborator Amos Tversky.
A key cause of WYSIATI stems from the human brain’s tendency to put significance on information based on how recent and attention-grabbing it is – known in academic jargon as 'recency bias' and the 'availability heuristic'. Research shows, if unchecked, the recency and availability of information massively trumps its actual statistical significance in influencing our judgments and decisions.
A commonly cited example of this phenomenon in action occurs following natural disasters. Demand for insurance against the recent event spikes immediately after it has happened before slowly retreating. The grim irony here is that insurance cover is normally back to the pre-disaster level the next time it is actually needed.
For investors experiencing sharply falling markets accompanied by strong negative narratives – such as potentially far-reaching economic consequences from the spread of coronavirus – this means it becomes very hard to tune into alternative scenarios.
(3) Big loser
A third important factor dictating how we respond to financial loss centres on another Kahneman and Tversky discovery: the emotional pain wrought by a loss is roughly twice as great as the pleasure caused by an equivalent gain. This provides reason to believe the default setting for the average (perhaps almost every) investor is: 'sell low, buy high'. Loss aversion creates an inextricable pull towards panic selling as well as reticence to buy into a potential recovery as fear of further loss trumps the desire for possible gain.
The difficulty all humans have during extreme events in disentangling their emotional selves from their rational selves means it is important to have a plan in place to deal with a market melt-down - even if it is as simple as “do nothing”.
Follow this link for expert views about what to do in a sell-off.
