Managing your capital

What are the dynamics of the stock market in times of crisis?

We want to invest with our heads, but sometimes instinct takes over. Especially in times of crisis, like the current one. What is happening on the trading floor during the Corona crisis and how can insights from behavioural finance guide us?

Anxiety about the Coronavirus has seen the economy and the markets shift down a few gears. The fact that physical access to consumption has been limited provides only a partial explanation of the downturn. In comparable situations, companies and consumers have tended to be more careful with their money, especially spending. After all, with fewer people working and less income across the general population comes more uncertainty.

The Coronavirus is not only costing companies a great deal of money, it also means they have less money coming in. This translates into prices on the stock market. Investors are expecting less-than-rosy numbers in the (near) future and are factoring this into share prices. After all, investors do not just look at the current value of companies and their potential dividends, but mainly at their potential over the long term. That is why market charts generally show trends ahead of real economic statistics. 

Conflicting visions

The market is a fascinating interplay of supply and demand. Millions of transactions take place and billions of assets change ownership on a daily basis. For each of those transactions there are always two parties, each with a completely different vision. Looking down one end of a telescope is a seller who concludes that the cream has been skimmed. Looking at the very same share from the other end of a telescope is a buyer who does see growth potential and potential profit.  

Investing on instinct as well

How can one person decide that now is the time to sell while another is deciding that it is the time to buy? There are 1001 factors influencing such decisions. For a long time, we assumed that investors weighed such decisions based on facts and insights including expected price/profit, dividend yield, economic indicators and the quality of management. However, for a few decades now, behavioural finance has shed a more nuanced light on the subject. While we, in principle, invest with our heads, in practice we allow ourselves to be guided by instinct. It's no coincidence that we are discussing market ‘sentiment’.

While we, in principle, invest with our heads, in practice we allow ourselves to be guided by instinct.

Lack of competences?

In crisis situations like the one we are experiencing today, such dynamics come to the fore in a more dramatic way. The market can seem like a pinball machine. One moment, investors are sending shares to the depths only to send them skyrocketing again, barely a day later. In part, these drastic price variations can be explained rationally, as responses to impulses like a pep talk from central banks, new fiscal stimulus, triggered algorithms or positive news about the Coronavirus. But a certain amount of this behaviour is sheer panic, euphoria/overconfidence, speculation - all of which have nothing to do with a lack of competences. They are purely external influences that investors, however knowledgeable they may be, find difficult to ignore.

Financial resilience to loss

One of the influences affecting our decision-making is our natural aversion to loss. Nobel prize-winner Daniel Kahneman and Amos Tversky discovered that losing is twice as powerful an experience as winning. Negative feelings that come from loss are much stronger that the positivity that results from gains. There's no question of symmetry here. This leads to certain behaviour by investors. For example, it leads to being very focussed on the one investment that is in the red and neglecting investments that are doing well. Or it can result in selling an investment with the aim of preventing further losses, even though it is objectively better to buy more. Alternatively, it can lead to investing in defensive products that yield little or no return, and that erode purchasing power.

Contamination risk

While we generally make investment decisions ourselves or with an adviser, we also let ourselves be guided by others. In times of crisis like these, there are higher levels of 'contamination risk’ and 'herd mentality’ on the market floor. That is not necessarily a negative because sometimes it can really pay to do what everyone else is doing. After all, group dynamics can ensure that the damage remains limited: everyone else is taking cover, so the best thing I can do now is to sell my investments quickly. If the herd made a poor decision, it was in any case a collective decision. As an individual investor, you are not solely to blame because everyone made the same, incorrect assessment. Insights from behavioural finance indicate that loss is more painful when an investor has the feeling that they, and they alone, are responsible for their loss or limited profit. Following the crowd can, on the other hand, also be quite negative: it can lead to missed opportunities and a lower return over the longer return.

Short term

Investors hate uncertainty. This crisis brings with it not only market-related uncertainties. For many investors it feels even more oppressive because it has a direct impact on their lifestyle. Add to this mix a high dose of volatility, our natural aversion to loss and market news that is always just a swipe or click away... and it's easy to see how an impulsive decision is quickly made. Behavioural finance also teaches us that, in general, we prefer not to look very far into the future when it comes to investing. Experiments show that we are often inclined to opt for a smaller gain in the short term rather than a larger gain in the future. That is why many investors prefer to look at the current economic situation and short-term predictions, especially in crisis situations. 

Those who persevere, win

For both the novice and experienced investor, the message is still the same: investing is a long-term endeavour. However wildly the market has recently zigzagged and may continue to do so for a while: the dip and the volatility should prove to be irrelevant for those investing over the long term. The history shows that markets always recover and go on to climb further. For example, over the past 100 years the S&P 500 (and its predecessors) experienced 14 bear markets, but the index still recorded strong growth: from just nine points at the start of 1920 to 3,278 points at the end of 2019. 

Which investment solutions?

Opting for periodic investing; opting for solutions with capital protection; opting for flexible, mixed funds; opting for discretionary management... There are solutions for every type of investor that will kick the emotional component into the long grass, while preserving your peace of mind.

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