Fear, greed, and behavioral finance

June 2020

Key takeaways

  • Your clients may be finding themselves driven by a range of intense emotions amid the fallout from COVID-19.

  • Cognitive and emotional behavioral finance biases have emerged as some investors have been driven by fear and greed.

  • The behavioral finance biases currently affecting your Baby Boomer clients are not necessarily the same ones affecting your Millennial clients.

  • Communicating frequently with your Baby Boomer clients and ensuring that your Millennial clients understand the potential benefits of their long-term asset allocations may reduce their anxieties.

Fear, greed, and behavioral finance—an emotion, a learned behavior, and a maturing science, each helping to explain market movements amid COVID-19. With the unprecedented global health crisis clouding the horizon, your clients may be experiencing a range of intense emotions, leading to irrational behavior. Major crises are like petri dishes that culture behavioral finance biases, as the fallout from the novel coronavirus is effectively demonstrating.

Behavioral finance seeks to account for the cognitive and emotional effects of human nature on investment decisions, attempting to understand how our innate tendencies lead us to behave. With a perspective on global equity markets through a behavioral finance lens, this edition of our recurring insights focuses on fear- and greed-driven biases that have emerged during the global pandemic. The goal of this commentary and others in the series is to provide advisors with insights into the potential motivations of their clients, and to help advisors incorporate behavioral finance into their practices.

A petri dish for behavioral finance biases

Global uncertainty and the unprecedented health crisis are rendering historical data somewhat irrelevant, creating a substantial challenge for advisors, analysts, portfolio managers, and retail investors alike. Estimating a company’s future profitability in this environment is almost as much of an art as a science. So it’s perhaps unsurprising that sentiment shifts surrounding fear and greed seem to be driving the markets more than the questionable economic fundamentals.

Loss aversion and other fear-driven biases

Some biases are primarily driven by emotions, including fear. And at the forefront of these fear-driven biases is loss aversion, which made its presence known as COVID-19 became a global pandemic. Studies by Nobel Prize winners in Economic Sciences suggest that the desire to avoid losses is nearly twice as great as the hope of earning a reward, making loss aversion a powerful motivator.

Staying too close to home

The home bias is another behavioral finance effect that has been present as many investors have sheltered in place. This bias reflects our built-in preference for the comfortable and familiar, creating a desire to overweight domestic and local securities. U.S. investors aren’t alone in potentially facing this predisposition, either. Investors in Australia, Europe, Japan, and the U.K. have shown a similar preference for emphasizing their country’s securities.

Panic buying of toilet paper in perspective

When facing uncontrollable crises, people often focus on what can be controlled, like having enough toilet paper. As the novel coronavirus metastasized into a global pandemic, many store shelves were stripped bare amid panic buying. A vicious cycle subsequently emerged, as many people surrounded by empty shelves and overloaded carts felt that their worst virus fears were being confirmed. This illustrates the confirmation bias at work.

Don’t get trampled by the herd

Herding is another fear-driven bias that is playing a role, representing our innate desire to align our actions with those of our peers. The herding bias has been known to fuel “momentum investing,” which can cause investors to chase stocks higher or lower. Sharp market shifts during the dot-com bubble, the 2008 credit crisis, and current crisis illustrate the potential effects of this behavior.

The tangible results of fear-driven biases

These four biases started working in concert by late February. Fueled by loss aversion, frightened investors sold stocks as if in a herd, not wanting to be the last to liquidate. Emerging markets suffered the most, as home bias effects convinced many investors to repatriate into locally denominated cash-equivalent securities. As the decline steepened, some investors’ worst fears were validated. From a record high in late February, the S&P 500® Index fell 34% by late March, the fastest and sharpest sell-off in U.S. stock market history.

Chart - Faster bear market

Greed-driven biases tend to be cognitive in nature, and the overconfidence bias is a prime example.

The costs associated with overconfidence

Greed-driven biases tend to be cognitive in nature, and the overconfidence bias is a prime example. Research suggests that a majority of investors consider themselves better than average at making decisions. However, for investors whose confidence has risen to extremes, the results may lead to overestimating the value of their insights, inappropriate risk taking, and excessive trading. As shown in the chart below, trading volumes spiked during the first quarter.

Chart - Trading levels

Data availability through a biased lens

The availability bias is another cognitive behavioral finance effect that can cause trouble for investors. Although we may believe that we evaluate data objectively, human nature can potentially lead us to employ a far less calculated approach and instead revert to mental shortcuts. Our memories are filtered through our beliefs, expectations, and feelings, as well as media exposure, so what we think to be “truth” may be somewhat relative, according to the availability bias.

Boomers may be rushing back into stocks

The stock market’s intermittent rallies may be triggering a confirmation bias effect in some of your overconfident Baby Boomer clients, tempting them to increase their equity exposures amid hopes that we’re starting to shift toward more normalized times. Many Baby Boomers (1946–1964) enjoyed more than a decade-long bull market during their formative investing years, lending strength to expectations that stocks will only head higher over time. Climbing the corporate ladder was a big focus for many Baby Boomers, and high-stakes risk taking was often required. However, becoming overexposed to risk when the markets are this unsettled might cause problems.

Millennials are likely staying on the sidelines

By comparison, your Millennial (1981–1996) clients are likely to be underinvested in U.S. stocks and may wish to stay that way. The formative investing years for Millennials occurred in the aftermath of the dot-com bubble and the 2008 credit crisis. Investors in this generation probably watched their parents struggle through financial hardships, causing Millennials to be relatively risk-averse where equities are concerned. When considering the data-driven nature of Millennials, your clients from this generation may be focused on the historically quick transition from bull to bear markets, and on the global mortality rate associated with COVID-19. Reminding these clients of the potential long-term benefits of an appropriate allocation in equities might be necessary to give them a better chance at a sound financial future.

Help your clients now, and later

If today’s COVID-19 reality is throwing off your game, you’re not alone, and your clients are probably feeling equally disconnected from a sense of “normalcy.” Given the unprecedented times, we suggest three action items that may help to keep you and your clients feeling better connected and more confident about tomorrow.

Action items for a better tomorrow

First, help your clients focus on the long-term. In ballet, “spotting” is a technique where dancers fixate on a forward-looking point while performing a series of pirouettes. This technique helps them keep track of their positions even as their bodies spin as if on an axis. Similarly, help your clients focus on their financial futures during a period when the markets appear far more driven by emotions and behavioral finance biases than by fundamentals. Just as an unfocused ballerina is likely to become dizzy and eventually spin out if control, so too might your clients lose their balance amid the market upheaval without your help to focus on the long term.

Second, consider reevaluating your clients’ risk tolerances. Changing financial circumstances, health concerns, or extreme anxiety over the sharp increase in market volatility may find your clients better aligned with a slightly different asset mix. If the need for a reallocation of resources becomes clear, revise your client’s long-term asset allocation plan, accordingly. Next, implement slowly or quickly depending on the client’s comfort level, and then help your clients stick to the plan.

Third, remember that reaching out to clients more frequently during uncertain times can potentially ease their anxieties and provide reassurance that they’re still on track for potentially reaching their long-term financial goals.

About the author

Omar Aguilar

Omar Aguilar, Ph.D.

Chief Executive Officer and Chief Investment Officer