Question

Using behavioural finance theory, discuss the potential impact of COVID-19 pandemic on financial markets and investors’ decisions (maximum 400 words).

Answer 1

The COVID-19 pandemic has resulted in dramatic economic effects, characterized by excessive stock price volatility and a market crash. Some of the phenomena in effect during the crisis, such as the excessive volatility and the unshaken confidence of financial institutions, are insufficiently explained by the traditional finance paradigm.

Markets may be highly volatile for some time, and that will make price discovery more challenging. Rapid liquidity shifts and unexpected demand drops are already causing some challenges for market participants that need to see pricing. Similarly, volatility and associated dislocations can limit the effectiveness of hedging relationships.

According to the International Monetary Fund (IMF), the world economy will face the worst recession
since the Great Depression.

Stock prices primarily reflect investor beliefs about the value of a company. Changes in investor beliefs can cause the value of a company to change due to the market forces of supply and demand. Prices decrease when more people want to sell a stock than buy it.

Traditional economic theories cannot fully explain the movement of the stock market. Behavioural economics has revealed that stock prices can change due to biased or emotional decision making. Investors tend to make more decisions based on biased or emotional decision-making during times of increased volatility, such as the COVID-19 pandemic. Three key biases that become more common during market turbulence are affect, herd behaviour, and loss aversion.

Affect

Affect is a decision-making shortcut in which good or bad feelings influence decision making. These are emotional, rather than logical, responses to information. Affect typically changes how individuals perceive the benefits and risks of decisions. In general, if information relating to the decision makes us happy, we tend to perceive the benefits of the decision as higher. We see decisions as riskier if the information relating to the decision causes negative emotions.

Due to Affect, emotions play an important role in investor decision making. This is especially relevant during times of market turbulence. One of the most significant emotions during these times is fear. During a sudden drop in markets, fear is triggered in many investors. This fear may cause some investors to overestimate the risk that they will lose all their money. This is irrational if they have a well-diversified portfolio. The irrational fear of losing everything may cause them to panic and needlessly sell assets for a loss.

Herd Behaviour

Herd behaviour occurs when individuals do what others are doing rather than making decisions based on their own knowledge and information. Herd behaviour can lead to entire groups making irrational decisions. This commonly occurs to investors during market bubbles and crashes. During a bubble, irrational optimism drives the prices of assets well above their fundamental value. Collective pessimism often plays a significant role during market crashes.

New information, such as a global pandemic, can cause a rational decrease in stock prices. The new information will cause some investors to become pessimistic of the value of certain stocks and they will sell. Herd behaviour may take over at this point as investors begin to sell merely because others are selling. This collective pessimism can lead to a crash that causes the prices of stocks to drop below their fundamental value.

Loss Aversion

Individuals do not feel gains and losses equally. We psychologically experience losses twice as strongly as gains. Put simply, losing $100 hurts more than gaining $100 feels good. Loss aversion becomes very problematic during market turbulence. Even if the value of your portfolio is the same before and after the period of turbulence, it will feel as though you are worse off.

One way that loss aversion affects our decision making is that it makes us try to avoid risk. The pain experienced from losses during market volatility can lead to investors becoming risk averse. This is problematic since all investing involves risk. Risk averse investors may overestimate the risks associated with their portfolio and decide to change their investment strategy to a more conservative approach that is not aligned with their long-term investment goals.