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  • Antal Ertl

Are We Right to Panic?

After what some called the worst week since the 2008 crisis, we felt that we should address some of the behavioral effects in the financial markets. More than 3 trillion dollars have just disappeared in the global economy. According to Bloomberg news, the world’s 500 richest people lost approximately $444 billion dollars, and as of February 28th, the Dow Jones Industrial Average lost more than 12%, while the S&P500 index lost 11.5% of its value. While this tumble in the financial markets is as appalling as it is baffling, economists, financial experts and investors try to find out whether such a decline is justified.

The story behind the decline is pretty straightforward: as the potential consequences of the COVID-19 virus began to be perceived as direr, the market reacted. Due to the precautious actions taken by both governments and companies, such as reduced working hours, travel bans, and, in some cases, closed factories, a decline of yield and production is expected. Such market corrections occurred 26 times after the Second World War (Goldman Sachs), and further corrections could be expected in the following months.


The key word in the last paragraph is expectations. Now, obviously, financial experts and economists have calculations and models on the effects of such external shocks (in economics terms).


Efficient markets, with inefficient agents


It is worth talking about one hypothesis in particular: The Efficient Market Hypothesis (EMH), proposed by Eugene Fama. In short, EMH is a model for the financial and capital markets which states that the current prices on the market reflect all available information on that particular stock. As such, the recent surge of Tesla stocks means that some meaningful information surfaced, thus expectations towards Tesla sky-rocketed. It is important to note, however, that not even Eugene Fama thinks that markets are perfect in the short run: he does, however, emphasize that this is a model, and models are always wrong (as George Box famously put it: all models are wrong, but some of them are useful).


Fama received a Nobel-prize for his theory in 2013. Funnily enough, that year he shared the economics Nobel-prize with Robert J. Schiller, who regarded his theory as “one of the most remarkable errors in the history of economic thought”. He is one (if not the) key figure of behavioral finance, along with Richard Thaler. In his work, he analyzed markets and tried to find behavioral patterns on the markets. Along with writing the book “Animal Spirits” with George Akerlof, he is most famous for the behavioral analysis of market bubbles and the creation of the Case-Schiller repeat-sales index for the real-estate market.


Schiller’s proposition of the market is quite different of Fama’s – in his theory, markets are inefficient, and mostly driven by psychology ­– as such, you can easily beat the market as an investor (watch his case against EMH here: https://www.youtube.com/watch?v=Tn-A7eCUrYk). Interestingly enough, he and Fama seem to agree on a lot things. But one of the key aspects that they disagree on is the existence of “bubbles”, that is: whether over-pricing of an information can occur on the markets. If it comes down to the individuals – especially during turbulent times – Schiller might have got a point.


During a crisis or a panic, risk aversion comes into play. We know from Kahneman and Tversky (1979) that not only we are bad at probabilities, but we also perceive them incorrectly. This was depicted in their weighting-function, which can be seen below:

In short, this states that we overvalue the occurrence of low-probability events, and relatively undervalue certain effects. For us in this context, the overvaluation of low-probability events is key, as such it can be utilized to explain the recent unprecedented movement that occurred in the markets. Accordingly, as the market participants overestimated the probability of the coronavirus being a pandemic event, which, based on past occurrences, is highly improbable, market overreaction that does not necessarily reflect the economic reality might have ensued. This, in the context of Fama’s hypothesis, might imply that markets can be emotionally efficient, meaning that information by itself is not reflected in the market, instead, it is the information after being filtered by emotions and biases that the market reflects.


The availability bias is another aspect that might be involved, relating to the tendency to determine the likelihood of an event’s occurrence by the simplicity to retrieve it from the memory. To give you an example: people are more afraid of travelling by plane than they are of travelling by car. Why? If there is a plane accident, it is all over the news. Car accidents are more likely to be reported in traffic news. Because of this, in our mind and in our memories, plane accidents were more impactful than car accidents. In the context of markets, wide coverage of coronavirus news gives the market participants perception that the situation is exacerbating, leading to the overestimation of the possible effects. Yet, when one realizes that total flu deaths every year worldwide is around 389 000, the 2942 deaths caused by coronavirus appear strikingly low. However, the market acts as if it were exactly the reverse. It is a common observation that markets realize this overreaction sooner or later, and a strong retracement follows. Observation of similar past virus outbreaks reveals that twelve months after the overreaction occurred, the markets increased, on average, by 13.62%, emphasizing that the initial concerns were significantly overestimated. Of course an argument can be made that the market is pricing the current expectation of decrease in production, but historically this is still an overreaction – maybe this is the market’s way of “better safe than sorry”.



Clearly, making investments in such a volatile environment depends on your time-horizon: if you are a short-term investor, you might be inclined to invest in safe-havens. If you are a long term investor, however, you might see this as an opportunity, as you are able to buy stocks at a lower price, thus your long-term returns might increase. And, of course, risk appetite is key in both cases.


Panics, safe-havens and animal spirits


But what do investors do when there is panic in the markets? They turn to so-called “safe haven” investments. Investors buy these assets to reduce their exposure to losses during volatile times on the market. Examples include gold (and other commodities), treasury bills (considered to be risk-free, due to the government being the debtor), and defensive stocks. Defensive stocks include companies whose products’ demand can be described as rigid – food, medicine, and all sorts of FMCG markets, all due to the simple fact that there is constant demand for these goods. Most of these are coming from rational expectations, that in the future the demand for these is still going to be high. Investing in gold, however, might not seem as practical as the other ones. One can argue that this is just a “reflex” – after all, coming from a philosophical question: why does gold have such an important intrinsic value, even if it’s not as widely used as it once was? And we have yet to talk about the elephant in the room: cash.


During major economic downturns, people liquidate their investments and try to get as much cash as possible. This was mainly true during major uproars and bank-panics in the 19th and 20th centuries. A famous example is the Bank Panic of 1907. In short, what happened there is that during a recession, one of the largest trust companies of New York, called Knickerbocker Trust Company, was filed for bankruptcy – immediately, people lost their confidence in trust companies, and they tried to gain as much cash as possible. The consequences were decimating, and later it served as a reason to introduce the final lender, the Federal Reserve System in the United States.


Now, we can argue that this story bares some similarity to some of the department stores being overrun, and a lot of sustainable food being purchased. Due to the fear of the spread of the virus, everyone is preparing for a worst-case-scenario. Obviously, Keynes’ Animal Spirits is in play here – there is a sudden decrease of trust, and an increase in uncertainty. This mentality of the market, however, may be completely unsupported by fundamentals. As such, information asymmetry plays a huge role: we do not have complete information about the situation (reading every news article about the effect does not provide us with actual understanding on the effects, rather just the mood of society and the markets). Some actors might have better information on the topic, but it is very hard do distinct these in the noise generated by events.


Confirmation bias is also an important factor in this situation. Confirmation bias is when you start to interpret every information that you gather in a way which supports your prior beliefs. Basically what this means is that you decide on how to interpret a situation, and then you frame every new information so that you think that your “hypothesis” is more and more probable, thus leading to inductive reasoning. You can, however, defend yourself against this, but you have to be extremely conscious about how you interpret information.


And lastly, from a game-theoretical point of view, it might be worth to make some precautions. If everyone else is making these precautions, you might as well do it – the (perceived) possible losses by not participating in herd behavior might be greater than the gains by not complying – leading to a perverted “fear of missing out”. Again, the “better safe than sorry” argument can be made, with the condition that buyer’s remorse is actually more probable than one might imagine (think back on the weighing-function of Kahneman and Tversky).


So what happens?


Funny you should ask – no one knows. Unfortunately, no economist has the abilities of the Old Testament prophets, nor of Nostradamus. We cannot say what will happen – we have models, and some fundamental changes that we can rely on, but ultimately, behavior of the stock market can be very hectic and sometimes inexplicable, due to animal spirits and herd behavior – as Schiller and Akerlof elaborated on it ten years ago. But such great, sudden changes should be perceived and interpreted with caution – as explained, after such market corrections, there were other corrections in the following months.


As for forecasts and expectations, and old joke comes to mind: why did God create economists? To make weather forecasters look good.



References and Further Readings


Akerlof, G.A., Shiller, R.J. (2009): Animal Spirits: How Human Psychology Drives The Economy and Why It Matters for Global Capitalism. Princeton University Press, 2009.


Fama, E.F. (1970): Efficient Capital Markets: A Review of Theory and Empirical Work. The Journal of Finance Vol. 25, No. 2, Papers and Proceedings of the Twenty-Eighth Annual Meeting of the American Finance Association New York, N.Y. December, 28-30, 1969 (May, 1970), pp. 383-417.


Kahneman, D, Tversky, A. (1979) Prospect Theory: An Analysis of Decision under Risk. Econometrica, Vol. 47, No. 2. pp. 263-291.


Loewenstein, G., and O’Donoghue, T. (2004). Animal Spirits: Affective and Deliberative Influences on Economic Behavior. Pittsburgh, PA: Carnegie Mellon University.


Moen, J.R., Tallman, E. W : The Panic of 1907. Federal Reserve History; https://www.federalreservehistory.org/essays/panic_of_1907


Tversky, A., Kahneman, D. (1991), ‘Loss aversion in riskless choice: A reference-dependent model’, Quarterly Journal of Economics, vol. 56, pp. 1039-1061.


Veblen, T. (1899/1979): The theory of the Leisure Class. Penguin Books, Harmondsworth.



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