To Buy or Sell? Financials in the days of COVID-19 (and stay home for now!)

Like everyone, I too was taken aback by the overwhelming wave the Coronavirus had on international health, and international financial markets. And I too, like so many others who invests in the stock market, lost a lot of money (relatively speaking…). In one of my conversation with a friend about what to do with our money that is invested in the stock markets, 2 opposing yet basic theories rose: take the money out or keep holding until the storm will pass.

That conversation inspired me to go into the research of behavioral finance and behavioral economics to see what science had to say about this. And since I am single and with spare time while working from home, under a partial lockdown in Israel, I was able to read a few articles on the subject, and provide here a few interesting conclusions from them.

It goes without saying that I am in no way qualified to give financial advice, and so do not look at this blog post as claiming to give such advice, and I definitely welcome your opinions, thoughts and further studies and research on the matter.

First, let’s define a few things:

1.      We are not talking about pension funds. The issue here is one’s savings funds.

2.      The question is whether you believe staying in the market despite the current loses is better than going out of the market. With or without the intention of going back in.

The second point and question depend on one’s beliefs. Or biases. According to a predominant principle of classical economic theory, investment decisions are affected by rationally formed expectations by making use of all available information in an efficient manner. Investor behavior however often deviates from logic and reason, and investors display many behavior biases that influence their investment decision-making processes.

As economist John Maynard Keynes argues in The General Theory of Employment, Interest and Money that the “long-term investor” is concerned with the average opinion and the criticism of others in order to make a sound judgement. Which leads us to investment biases:

Some of the more common behavior biases are below, and think while reading this which bias applies to you:

1.      Representativeness, which results in investors labeling an investment as good or bad based on its recent performance (like buying stocks after they go up).

2.      Regret (loss) aversion, where the emotion of regret is experienced after making a choice that turns out to be either a bad or inferior choice, which can result in taking less risk.

3.      The disposition effect, which refers to the tendency of selling stocks that have appreciated in price since purchase (“winners”) too early and holding on to losing stocks (“losers”) too long.

4.      Familiarity bias is when investors have a preference for familiar investments despite the seemingly obvious gains from diversification.

5.      Anchoring is the tendency to hold on to a belief and then apply it as a subjective reference point for making future judgments. Anchoring occurs when an individual lets a specific piece of information control his cognitive decision-making process.

6.      Self-attribution bias is when an investor tends to attribute successful outcomes to their own actions and bad outcomes to external factors.

7.      Trend-chasing bias is when investors often chase past performance in the mistaken belief that historical returns predict future investment performance.

In addition, many investors can be classified as either overconfident or status quo investors. Overconfident investors tend to be overly active traders, as they may display overconfidence in both the quality of their information and their ability to act on it. Many studies showed that people tend to overestimate their skills, abilities, and predictions for success (just ask a group of people if they think their driving skills are above average or below average). Status quo investors display a lack of attention to managing their portfolios and tend to default to the same judgment or accept the current situation[1].

Why is the above list relevant? People must consider both the risk and the ambiguity of future outcomes when making investments. So tackling one’s biases can help in doing just that.

Let’s define risk and ambiguity. Risk refers to events for which the probabilities of the future outcomes are known; ambiguity refers to events for which the probabilities of the future outcomes are unknown. Studies argues that most people are ambiguity averse, that is, they prefer a lottery with known probabilities to a similar lottery with unknown probabilities. Maybe because with the former we can (or think we can) calculate the risk and act accordingly.

One study found that ambiguity aversion (the preference for known risks over unknown risks) is negatively related to foreign stock ownership but positively related to own-company stock ownership. The same study also found that people are generally ambiguity averse towards tasks for which they do not feel competent, and much less ambiguity averse towards tasks for which they believe they have expertise. Again, here we must note to tackle the self-attribution bias. This study also shows that respondents with higher ambiguity aversion were significantly more likely to actively sell equities during the financial crisis of 2008[2]. 

Another study found that investors hold on to bad investment for much too long which can be related to the disposition effect that could be explained by a possible aversion to loss. By doing so, investors lose the opportunity of selling the losing security in order to acquire a potential gain by investing in another security. Thus, causing the disposition effect or the sunk-cost fallacy. 64.3% of respondent would rather hold on to their investments for a little while longer even though the stocks purchased have underperformed leaving the investor with a huge loss. In addition, only a maximum of 23.8% of the respondents from the sample would sell their investments and take their losses according to the survey[3].

On the other hand, another study post-the 2008 financial crisis found that individual investors continue to trade and do not de-risk their investment portfolios during the crisis. Individual investors also do not try to reduce risk by shifting from risky investments to cash. Instead, individual investors use the depressed asset prices as a chance to enter the stock market[4]. Whether these investors are ambiguity averse or not is unclear.

A study looking at the financial crisis in Korea at 1996-1998, and making a comparison between local and foreign institution and private investors, found that during the crisis, foreign investors had the tendency to engage in positive feedback trade (buying when prices rise and selling when they fall), selling recent worst performers more aggrievedly. When checked for earnings, they found that a negative feedback trading strategy (buy stocks when prices decline and sell stocks when prices rise) would yield better results for 1-2 months – 9% monthly rate. It also found the almost all groups of foreign investors exhibit herding trading, but resident institutional investors less so. Herding is the tendency to of a particular group to mimic each other’s trading. Individual investors herd almost twice as institutional investors[5].

An interesting study conducted on the German stock exchange post the 2008 financial crisis shows that investors with no positive market episodes are significantly less likely to exit in 2008. Better timing experiences are also associated with a lower likelihood of exit and there is no evidence that investors learn from poor market timing. Unfortunately, we do not have the earnings of each group post crisis in this study.

Regarding the decision whether to exit the market in 2011 - Longer account tenure is associated with a lower exit likelihood but is only significant for 2011. Crisis-related experience, or lack thereof, appears to be a more economically significant determinant of stock market exits: Investors who were present for the run-up and fall in stock prices around 1999/2000 are 1.3% less likely to exit in 2008, relative to an exit baseline of 5.4%. Investors who opened an account after March 2009, and are thus deemed to lack any crisis experience, are almost 2% more likely to quit in 2011 than their otherwise similar peers - almost half the exit baseline of 4.3% for 2011[6].

Unfortunately, I couldn’t find more studies such as the study post the Korean financial crisis which also compared earning. Though such a study will also be limited by the post crisis analysis – how long are we measuring the earnings for post crisis?

What I do think we can all gain from this is, firstly, to know who we are – what biases impact us and how can we minimize if not eliminate their impact. The same goes as to our experience in the stock market. Secondly, each one needs to define their own strategy – long term investment, how much “spare money” is invested and whether they plan to re-enter the stock market post COVID-19. There is always a question of when to enter, but that can be the subject of another post.

If you have access to studies that conduct an earning-comparison between investors who left the market and those who stayed, please share it with me here so we can all learn from it (actual scientific studies, not news-media publications).

In the meantime – stay the home, be safe and let’s get over with this so we can go to the beach and play volleyball !

  References:

[1] How Biases Affect Investor Behaviour, By H. Kent Baker and Victor Ricciardi

[2] AMBIGUITY AVERSION AND HOUSEHOLD PORTFOLIO CHOICE: EMPIRICAL EVIDENCE, Stephen G. Dimmock, Roy Kouwenberg, Olivia S. Mitchell, Kim Peijnenburg

[3] The Impact of the Sunk Cost Fallacy and Other Behavioural Biases on Individual Irish Investors, Stefphane Samantha Percival

[4] Individual Investor Perceptions and Behavior During the Financial Crisis, Arvid O. I. Hoffmann, Thomas Post, Joost M. E. Pennings

[5] Foreign Portfolio Investors Before and During a Crisis, Woochan Kim, Shang-Jin Wei

[6] Individual Investors' Trading in Times of Crisis, Daniel Dorn, Martin Weber