There is a famous behavioural finance test.
Imagine you have to choose between two investments:
Investment A gives you a safe return of $10,000
Investment B has an 80% chance of giving you a return of $12,500 and a 20% chance of a return of $0.
In this case, most investors would choose Investment A because they are risk-averse and the additional gain of $2,500 for investment B is not worth the risk of losing all the gains.
Now imagine you have to choose between two other investments:
Investment C gives you a safe loss of $10,000
Investment D has an 80% chance of giving you a loss of $12,500 and a 20% chance of losing nothing.
In this case, most investors would choose Investment D because the prospect of avoiding losses is motivation enough to choose the riskier asset.
This risk-seeking behaviour after incurring losses is what we witnessed in this crisis once again.
When investors got hurt by the Covid-19 crash in March, they tried to make up their losses as fast as possible. This meant doubling down in April and in many cases buying leveraged investments like stock options to turbocharge returns.
So far, this has gone well since markets have recovered nicely since April. But what if markets have another down leg? What if a second wave of the pandemic triggers another crash? Will investors be able to sell in time to lock in their gains since April or will they hold on to these investments for too long and experience an even bigger hit in case of another down leg in markets?
I don’t know what is going to happen in the markets and if investors will take profits in time, but I do know that the investors who are most likely to have levered up their portfolio since April are probably the investors who can handle a loss least well.
A new study used laboratory experiments to see how investors reacted to extreme market moves. These investors were invited to play an online investment game where the chance of their investments making small profits or losses and behaving in an orderly fashion was c. 99.33%. But with a chance of 0.66%, an extreme loss occurred that would wipe out more than half of an investor’s assets. How would investors react after they had experienced such a loss?
Turns out that compared to investors who did not experience such a black swan event, more investors increased their investments after the event. And the investors who levered up the most were the investors with the higher risk aversion. They were so eager to avoid losses that they took on significantly more risk than the average investor.
Investor reaction to an extreme loss
Source: Corgnet et al. (2020).
What I find most interesting about their experiments, though, is that the behaviour of investors who experienced the crash in their portfolios is different from the behaviour of investors who observed the crash but weren’t invested.
Investors who observed the crash but did not suffer any losses themselves did not increase their investments. Instead, they tended to decrease their investments and became more defensive. How defensive investors became in reaction to an observed crash depended on their availability bias.
Availability bias describes our tendency to overweight a recent event from occurring again in the future. Events that are not readily available in our memory tend to be given a lower probability than events that we can easily recall or that we have recently experienced. Thus, the more an investor is prone to extrapolate the recent past into the future, the more defensive they became in reaction to a crash.
Investor reaction to an observed loss
Source: Corgnet et al. (2020).
What this shows is what every experienced investor already knows: You can only learn so much about investing from a book. You have to be invested and experience markets first-hand with your own money to understand how a crash feels and how elated and greedy you can become in a bull market. Luckily, with the events of 2020, a whole new generation of investors just learned that lesson first-hand.