The Biased Investor: Market Downturn Edition

When it comes to behavioural finance, most people know which biases sit at the heart of investing. Hell, even I and several friends and colleagues have written articles on this, on this blog alone. But, as any good behavioural scientist should be able to tell you, biases depend highly on the context they’re operating in. And investing is no exception. Investing is easy when the markets are up. Money is being made and we’re all having a good time. But what if markets are down?

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Some of the oldest behavioural science research (by Kahneman and Tversky, of course) shows us that behaviours differ quite significantly when shifting from the domain of gains, to the domain of losses. Indeed, this is a core axiom of Prospect Theory. In gains (market upturn) people are risk-averse, preferring certainty over opportunity. In losses (market downturn) people become risk-seeking, preferring the opportunity (of not losing anything) over the certainty (of losing something). And this can lead to some odd behaviours. So what do we expect to see in a market downturn? 1. Loss Aversion – but in the worst way People are loss averse, we really don’t want to lose our money. So what tends to happen in a market downturn? Well, people pull their money out of the market to make sure they don’t lose (any more). Issue is, research has shown time and time again that people fail to ‘time’ the market. Meaning that when people pull money out of the market out of fear, they’re often too late. Rather than minimizing losses, they’re realizing them. Because as long as you don’t cash out, you haven’t realised the loss. The market can go back up again. If you’ve got time to wait it out. 2. Risky Business For those who are still happy to remain in the (stock) market, or who are happy to continue any form of investing, the moment is going to come that as the circumstances have changed they’ll want to change their investment strategy; revaluate the portfolio; and maybe swap some asset (classes) out. But, if this is happening when investors have already started losing money, they’ll now be in a ‘loss frame’, meaning they’re likely to become increasingly riskier in their evaluation. We have seen this time and time again where during market downturns, people are open to investing in increasingly riskier assets. The crypto craze during the pandemic was a good example of this. 3. Scams galore! As markets go down, scams go up. I’m not making that up either. Scams and recessions go together like Elon Musk and the downfall of Twitter (now X *rolls eyes*). Scammers are some of the most behaviourally informed people out there – they know every trick in the book and then some. They know that as markets go down, people become fearful, more open to ‘alternative’ ways of making money, and this is where investment scammers do their ‘best’ work. If you’re being approached by someone you do not know about an amazing investment opportunity, block them via whichever means you can. No one is giving out ‘free’ investment tips via WhatsApp, Instagram, Telegram or TikTok. I’m also expecting to see a rise in pump and dump schemes as the market downturn worsens. Customer beware! 4. Crowd following The last thing I’m expecting to see is not really a bias, but a collection of biases. When we panic, like all animals, we look to our pack. We look to those like us and a bit above us in the (socio-economic) hierarchy for guidance. Our friends, family, those we follow on social media – someone must know what to do?! And here I expect to see bandwagon effects, leading to echo chambers, confirmation bias and action bias. You can call it herding if you prefer, the name doesn’t matter. Someone, somewhere will know what to do, we’ll seek out more information to confirm (not deny) their suggestions and we’ll choose to act on whatever (new) information we receive. Because when there’s money on the line, we need to act!

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As you can see, all these four subcategories of investment biases go hand in hand. One leads very much to the other: if you actively decide to invest passively, you won’t need to review your portfolio and strategy thereby not opening yourself up to crowd following and even scams might be largely avoided.

With a market down turn (imminent still, for some countries) how are you going to go about investing?