Risk seeking when fearful

Yesterday, I mentioned that I suspect that in a bear market, when investors are fearful, positive news may be incorporated more slowly than in a bull market. As is so often the case, somebody has done an analysis of that with somewhat surprising results.

In this case, the people in question are Simona Cantarella, Carola Hillenbrand and Chris Brooks. They investigated the combined effect of two well-known behavioural finance results.

Result number one is the dependence of risk tolerance depending on past losses or gains. Prospect theory teaches us that people who face gains are risk averse, that is additional gains create less and less ‘utility’ for the investor and thus increasing risk in the portfolio becomes less and less attractive. On the other hand, people who face losses are risk-seeking. They are willing to increase risk in their portfolio even if that means incurring even larger losses just to get a chance to ‘break even’ and avoid losses with a positive gamble.

Result number two is the dependence of risk tolerance on the emotional state of the investor. Investors who are in a good mood are more risk tolerant or even risk seeking. They take on more risk than people who are in a bad mood. The better the mood, the more tolerant to taking on risks investors get.

Now, what happens when you combine these two effects? I would have expected two things.

First that people who are in a good mood and faced with gains are taking on more risk than people who are in a bad mood. When facing gains, I would expect people in a good mood to take on relatively more risk than compared to people in a bad mood when facing losses (in other words, people in a good mood sitting on gains get exuberant).

Second, when people are in a bad mood, they take on less risk than people in a good mood. When facing losses, people in a bad mood select increasingly less risky assets compared to people in a good mood (i.e. they become catatonic).

The results of the study with 60 volunteers showed that the first effect is indeed correct. People who are sitting on gains and are in a good mood become truly exuberant and take on more and more risks.

But the second effect did not show up in the experiment. Indeed, when sitting on losses, people in a bad mood took on more risks than people in a good mood sitting on losses. In other words, when it comes to investors sitting on losses, prospect theory dominates and the desire to make up losses through increasingly risky investments (even if the expected returns do not compensate for the risk involved) is more important than the negative mood of the investor.

What does that have to do with my hunch from yesterday or even the current bear market? It tells me that in a bear market, investors will try to find the next best investment that provides hope for a recovery in fortunes. But this promise is easier to find for stocks in the media or present in the minds of investors. Thus, in a bear market, investors sitting on losses will likely flock to large and mega cap stocks with good news as a bet to make up some of their losses. Stocks that are less well-known or less covered in the media are easily ignored in this environment leading to slower incorporation of news into the share price. In essence stock picking in the small- and mid-cap space should become easier, and the outperformance of active fund managers should increase as they recover from the bear market.