Our whole approach to Market-Thinking is based around the psychological behaviour of markets and trying to make sense and anticipate the behaviours of our three key ‘tribes’ – traders, asset allocators and long term investors. Much of the analysis we used is captured under the broad subject of behavioural finance, so we thought it interesting to see how these tools might be applied to the current ‘madness of crowds’ .
“Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, one by one.”
Charles Mackay author Extra-ordinary Popular Delusions and the Madness of Crowds
The broad tenets of behavioural finance are that a) far from being rational, markets are driven largely by emotion b) loss aversion makes people sell winners and run losers c) people tend to follow herd behaviour. The behaviour of governments and populations during this extra-ordinary moment in time certainly fit these criteria as well as having resonance with some of the equally ‘mad’ behaviours in the past as chronicled by Charles Mackay
Let us therefore consider in a bit more detail some of the key points attributed to Behavioural Finance and see how they might apply today. For simplicity for most we have borrowed the broad definitions and descriptions from the Corporate Finance Institute (linked) and then added our Covid ‘take’. Many of these also map across to another concept we have discussed which is Logical Fallacies, so we highlight these as well where appropriate. Indeed once you are aware of the logical fallacies, almost every ‘argument’ currently being advanced across a wide range of issues, not just Covid, tends to collapse almost entirely. So be careful, it’s a slippery slope! (which is of course also a fallacy).
#1 Loss Aversion
Loss aversion is a tendency for investors to fear losses and avoid them more than they focus on trying to make profits. Many investors would rather not lose $2,000 than earn $3,000. The more losses one experiences, the more loss averse they likely become.
Loss aversion is one of the more familiar of the Behavioral Finance Biases and was highlighted by Nobel prize winner Daniel Kahnman in the best seller Thinking Fast and slow. This is why fear is a greater driver of behaviour in markets than greed is. In Covid terms this appears as a focus on the risk or loss from the virus rather than the gain from not closing the economy. Even once we learned how much less deadly the virus was than we first thought, fear dominated. The perceived loss of protection implied by, for example, halving the two metre social distancing rule – from 98.5% safe to 97.7% safe was considered far more important than the gain from enabling schools and restaurants to re-open. The notion of ‘you can’t be too careful’
#2 Framing Cognitive Bias
Framing is when someone makes a decision because of the way information is presented to them, rather than based just on the facts. In other words, if someone sees the same facts presented in a different way, they are likely to come to a different conclusion about the information. Investors may pick investments differently, depending on how the opportunity is presented to them.
Here we can consider the previous loss aversion and instead of asking whether we should reduce from 2m to 1m as in the previous example, we frame it as “Shall we increase from 1m to 2m?” The gain is then seen as an improvement in protection – from 97.3% to 98.5%, but the loss is now seen as “in order to achieve this, all schools will have to close, public transport and all other indoor capacity will need to be cut by 75% and most bars and restaurants will likely go out of business.” Put this way, the answer is likely to be very different.
#3 Herd Mentality
Herd mentality is when investors blindly copy and follow what other famous investors are doing. When they do this, they are being influenced by emotion, rather than by independent analysis. There are four main types: self-deception, heuristic simplification, emotion, and social bias.
This is perhaps the most obvious one as Covid-19 has been much more about Herd Mentality than Herd Immunity. In a list of logical fallacies this would be known as an ad populum, or the bandwagon fallacy – it is true because everyone else agrees. The use of opinion polls to instruct government policy codifies this. It also would appear under another logical fallacy which is the appeal to emotion.
#4 Overconfidence Bias
Overconfidence results from someone’s false sense of their skill, talent, or self-belief. It can be a dangerous bias and is very prolific in behavioral finance and capital markets. The most common manifestations of overconfidence include the illusion of control, timing optimism, and the desirability effect. (The desirability effect is the belief that something will happen because you want it to.)
So here we have a link to a logical fallacy in ‘the appeal to authority’, which is obviously the faith placed by the government as well as the public in the ‘Experts’ – who have demonstrated clear over-confidence in their predictions. There is also evidence of the desirability effect – such as the notion that the virus will be cured by a vaccine because we want it to be, while the illusion of control is shown in the wearing of masks and indeed lockdown, the idea that if we avoid contact the virus will somehow go away.
#5 Self Serving Bias
Self-serving cognitive bias is the propensity to attribute positive outcomes to skill and negative outcomes to luck. In other words, we attribute the cause of something to whatever is in our own best interest. Many of us can recall times that we’ve done something and decided that if everything is going to plan, it’s due to skill, and if things go the other way, then it’s just bad luck.
This trait is displayed in the fundamental belief that the infection rate from the virus has fallen due to lockdown rather than it having any other drivers. The fact that the virus has followed almost exactly the same path independent of measures taken is glossed over. In logical fallacies this could be described under ‘Ad Hoc, ergo procter hoc’ or the false cause fallacy; because a is followed b, b must have caused a. This currently applies to the wearing of masks; Asia has less deaths, Asians all wear masks, ergo masks prevent deaths. No other variables are allowed. This does not of course explain the difference between, for example, Canada and Australia, where similarities over lockdown, mask wearing (or lack of), diet, genetics, health and wealth have nevertheless resulted in very different outcomes.
#6 Narrative Fallacy
The narrative fallacy occurs because we naturally like stories and find them easier to make sense of and relate to. It means we can be prone to choose less desirable outcomes due to the fact they have a better story behind them. This cognitive bias is similar to the framing bias.
This is obviously a powerful driver of the trader behaviour we discuss in Market Thinking (hence the tag line of making sense of the narrative). The media will obviously focus on the more powerful emotional stories – the children, the small number of people without any underlying conditions, the medics and so on. In logical fallacy terms this is known as the anecdotal evidence fallacy. The data is too difficult to process so people hang on to the imagery. As Stalin once put it, a single death is a tragedy, but a million is a statistic. The fact that the total number of deaths without underlying conditions in England and Wales is only 1350 has more resonance if it is put in the narrative context that this is less than one single day of normal deaths. It is not of course, so people continue to be unduly fearful. Partly because of number 7.
#7 Anchoring Bias
Anchoring is the idea that we use pre-existing data as a reference point for all subsequent data, which can skew our decision-making processes. If you see a car that costs $85,000 and then another car that costs $30,000, you could be influenced to think the second car is very cheap. Whereas, if you saw a $5,000 car first and the $30,000 one second, you might think it’s very expensive.
This is most evident in the failure to look at the average number of deaths on a daily basis as mentioned in the previous example. In the UK for example, ‘normal’ deaths run at around 1500 to 1750 a day. In Germany, what has been described by Angela Merkel as the worst crisis in a century has actually led to fewer deaths than the 2018 flu season. By not anchoring to average deaths, or a normal flu season, the precautionary principle has meant that any and every death is somehow seen as ‘avoidable’ and requiring even stricter lockdown.
#8 Confirmation Bias
Confirmation bias is the idea that people seek out information and data that confirms their pre-existing ideas. They tend to ignore contrary information. This can be a very dangerous cognitive bias in business and investing.
Data on Sweden for example is compared to its Nordic neighbours, where it is seen as ‘bad’, even though its deaths per million are still below countries like the UK. The need for Sweden to have ‘failed’ reflects the pre-existing idea that by only partially locking down, Sweden was taking ‘massive risks’. In some senses this example also reflects the desirability effects – people want Sweden to fail otherwise total lockdown was not justified and it also represents the False Dichotomy fallacy, the idea that there are only two options – in this case Do nothing or lock down totally.
#9 Hindsight Bias
Hindsight bias is the theory that when people predict a correct outcome, they wrongly believe that they “knew it all along”.
Because ‘everybody knew’ that the UK should have banned immigration at the start of the crisis, many people want to do it now, even though the logic accepted at the time – that as it was already present and spreading it made no difference – is just as true now. On the other hand, there are benefits to knowledge rather than hindsight. What we know about Covid-19 now is different from what we knew at the time. For example, we now know that it isn’t a flu, but that it appears as one, but it can be treated as a normal pneumonia not a viral one. We know it can trigger an immune response over-reaction and that it also appears to produce low oxygenation of the blood and blood clots. We know that in many cases the respirators either don’t work or actually cause harm and so on. All of which allows us to deliver improved therapy.
#10 Representativeness Heuristic
Representativeness heuristic is a cognitive bias that happens when people falsely believe that if two objects are similar then they are also correlated with each other. That is not always the case.
The obvious example here is the fact that because Covid seemed like a flu (and health officials had prepared for a flu pandemic) that schools were shut as children transmit flu and other measures put in place such as ventilators. Even when it was realised that it was not a flu, schools remained shut and ventilators continued to be used for too long.
# 11 Sunk Cost Fallacy
This is one of the most dangerous fallacies at the moment as it is infecting government policy in getting out of lockdown. For investors this is a variation on putting good money after bad and doubling down on a bad decision. The idea that “we’ve come this far and can’t turn back now” is connected to loss aversion and is also lined to governments – and investors – looking to ‘save face’.
# 12 Endowment Effect
The idea that people will value an item more highly once they own it. In finance we see that once people own something they are reluctant to let go of it, especially companies that they have had a long time. In Covid world this might be thought of as the safety blanket of lockdown itself. Many people are not so much fearful of returning to work, or even catching the virus, but enjoy the endowment effect of ‘being safer’ by staying at home. This also links to a similar effects known as familiarity bias and the status quo effect.
Other logical Fallacies
There are many other observed behaviours that help explain the ways and the reasons why people are not behaving rationally over Covid-19. Moreover, in terms of other logical fallacies many of them are now being deployed by governments and supporters of lockdown policy to justify their behaviours. Most obvious is the 1) the burden of proof fallacy; instead of having to justify why the current rate of infection/level of deaths continues to require significant loss of liberty, people wanting to leave lockdown are required to prove it is 100% safe to do so. The burden of proof has been reversed. With the concepts such as the endowment effect, the status quo effect and familiarity bias, this can be particularly effective. We also have 2) the false dichotomy, the notion that there was not a spread of options between doing nothing and total lockdown, but rather only a binary option. This is at least partly behind the mis-representation of how ‘bad’ things have been for Sweden, which proves this dichotomy to be false. Third, we have multiple examples of 3) the straw man fallacy used “So what you are saying is that we should risk people dying just so the pubs can open?” Designed to shut down argument, this is used with other fallacies employed that are self explanatory, such as 4) Appeals to emotion and 5) Appeals to authority and occur in much of what passes for ‘argument’ at the moment. So too are 6) ad hominem attacks – the tactic of shooting the messenger if they disagree with the narrative. Currently there are many questioning the validity of lockdown who are facing this. We also have a lot of 7) ambiguity, whereby for example deaths with Covid present are represented as deaths from Covid, thus heavily inflating the figures and making it impossible to make valid international comparisons between governments that want to have high numbers to justify lockdown. and governments that want to have low numbers to appear effective. Keen observers will have spotted that all of these above listed tricks and fallacies are also regularly applied by advocates of Zero Carbon policies.
The bottom line then is that the madness of crowds over Covid-19 encompasses almost every aspect of behavioural finance in explaining the failure of people to act rationally and in their best interest while the full gamut of logical fallacies is being employed to somehow pretend this isn’t happening. As Charles Mackay said, people will only recover their senses one by one.
