Vaccines have a behavioural problem. If they are effective then they can eradicate a risk from our lives. The successful development of vaccines means that we are no longer exposed to a variety of illnesses that were debilitating and devastating. Yet because we don’t experience these traumas, it is easy to overlook the incredible benefits this scientific progress has brought society. Forgetting the risks that vaccines have removed means we are prone to understate their worth and give more weight to the other issues and concerns held about them.
But why does a problem concerning vaccines matter for investors? Because it is a vivid example of how the way we perceive and react to risks is about their prominence and how they make us feel. We worry about and respond to risks that are present and emotive, whilst disregarding those that are remote or removed.
This has profound implications for how we make investment decisions. The ‘risk as feelings’ hypothesis states that our emotions can dominate our behaviour[i]. Similarly, the affect heuristic is a decision making shortcut where our judgement is led by our emotional response to a situation[ii].
The risks that we are likely to consider as pronounced are those which are salient and we have recent experience of. When there is a severe market calamity (the Global Financial Crisis, for example) we spend the following years worrying if it will happen again and making sure our risk models now account for it. We are typically unprepared for the next crisis (a global pandemic, for example).
This is one of the reasons that tail risks are so problematic. They are risks that we have forgotten or never experienced. It is not simply that they are perceived to have a low likelihood of occurrence, but that they have no emotional resonance. The relationship is also circular – the less emotional significance something has the more we are likely to understate its probability (and vice-versa). That we are more likely to take out flood insurance after our house has been flooded is not because the probability of us being flooded in the future has changed but because we now perceive the risk differently[iii].
That our treatment of risk is driven by our emotions and feelings is likely to lead to odd and contradictory behaviours by investors. Some of us will entirely fail to protect ourselves from certain risks because we have never seen or felt them (inflation might be a good example of this).
By contrast, the capricious nature of financial markets means that some of us might be lurching from quarter to quarter attempting to manage the latest salient market risk we perceive. How many investors have been scrambling to restore at least some value exposure in portfolios as the price moves / stories around vaccines and Biden hint at a recovery?
Of course, the market is always hinting at certain outcomes prompting us to worry and fret; usually extrapolating randomness into concrete narratives. One of the largest behavioural problems investors face is how emotionally stimulating financial markets and all that comes with them are. So many of our investment decisions – from performance chasing to cashing out at the bottom of the market – are those which make us feel better right now. Short-term emotional benefits creating long-term financial costs.
The notion that it is the risks we see and feel that dominate our choices also ties into Bernartzi and Thaler’s behavioural explanation for the existence of an equity risk premium[iv]. It is the painful, short-term losses that provoke an emotional response and drive our behaviour; overwhelming the distant and sober long-term benefits.
The incentive structures for most professional investors also exacerbates the tendency to make short-term, emotional decisions. The more myopic the industry, the more stress, worry and emotion felt by decision makers. The more we judge investment decisions in binary terms as right or wrong, the less investors can protect against risks that never come to fruition.
Understanding how an investor is feeling when they make a decision is absolutely critical to judging the full rationale, but this is rarely even attempted. We want to hear about science and stories, not emotion. Even for the decision maker – unless it is a unmistakable moment of rashness – it is incredibly difficult to recognise the role of emotions in shaping a judgement.
When we consider how emotions influence our investment decisions, we often think only of ‘hot states’ and ‘in the moment’ decisions. These are important to protect against, but the issue is far greater than this. Changes in emotions and feelings can be the creeping growth of pressure and stress, or a slow shift in how we perceive certain risks. Even the absence of emotion can be problematic. How we feel matters much more than we like to think.
[i] Loewenstein, G. F., Weber, E. U., Hsee, C. K., & Welch, N. (2001). Risk as feelings. Psychological bulletin, 127(2), 267.
[ii] Slovic, P., Finucane, M. L., Peters, E., & MacGregor, D. G. (2007). The affect heuristic. European journal of operational research, 177(3), 1333-1352.
[iii] Kunreuther, H., & Pauly, M. (2015). Insurance decision-making for rare events: the role of emotions (No. w20886). National Bureau of Economic Research.
[iv] Benartzi, S., & Thaler, R. H. (1995). Myopic loss aversion and the equity premium puzzle. The quarterly journal of Economics, 110(1), 73-92.