Behavioral Finance in a Fearful Market

Scholars developed Behavioral Finance for times like these when human emotions dominate investment decisions. Even if the Ukraine invasion were to magically go away, the increased risk aversion of investors will take a long time to dissipate. This war comes on the heels of the Covid war which young investors add to their experience of having undergone two recessions since 2000. They would not be human if these market experiences had not made them more risk adverse.

Investors around the globe are still reeling the fallout of the Covid wars. The origins of Covid remain mysterious and ominous. Covid’s emergence built on a bed of growing distrust in the markets and the country. Covid and the war in the Ukraine, even with their chaos, have not fundamentally changed markets—they are operating as expected at clearing market prices. But they may have changed the risk aversion of investors, and mental health, for a long time.

Social distancing in a social animal

No social group, including investors, has special claim to mental health problems in the United States. Negative attitudes in the US spread across individuals in political groups and regions. The opioid epidemic exacerbated the deteriorating mental health situation in the country.

At the individual level, social distancing from Covid has negatively affected the health of the country. The stress at the individual level is also being seen internationally as international allegiances are reshuffled and we return to the great powers struggle of a century ago. There is speculation that Putin is in fact suffering from the effects of Covid isolation.

It should thus come as no surprise to us that the social isolation of Covid spills into international finance. The most obvious element until a couple of weeks ago, was the rise of Cryptocurrencies. Lack of trust in financial intermediaries and the government was a driving reason for the emergence of blockchain based financial assets.

Covid-driven supply line disruptions generated food anxiety around the world. We are well versed on the timing and distributional aspects of supply line disruptions that may be far from over. The impact of empty store shelves and the resultant food anxiety are a background reality for all of us. Now we are facing a systemic redirection of international flows especially in the energy sector that is inducing personal and financial panics around the world.

Gamify to control financial stress

The impact of war can be direct, in which its effect is clear. But the long-term effects for investors may be much more pernicious. And here we are not talking about risk avoiders. The risk averse, particularly the young, are changing their approach to risk.

As the chronic sensitivity among potential investors grows, technology companies have innovated to provide new investors with a way to buy and sell securities with little stress. Certainly, the gamification of investing is one way to circumvent rising risk aversion. The overall effect is that risk aversion will hold down all but a few sectors. Robinhood investors are typically in their 20s and 30s, many of whom may have little investing experience, looking for short-term gains. Those type of investors are not long-term investors, who have learned that investing requires risk tolerance.

No roaring twenties

Higher risk aversion demands higher expected returns to sustain investors. We have seen that with the rise of big tech companies and should expect that to continue as the new game-playing investors mature. These new Covid-trained investors are going to be more individualistic and more tech tolerant. We have already seen that the Roaring Twenties which so many had expected to follow the Covid years is unlikely to emerge. The young are in no mood to roar.

What the bond market is telling us

The reluctance of bond yields to give up much ground despite the Fed promising to raise rates in the face of surging inflation is a sign that investors are risk averse indeed. The financial markets are no longer expected to be informationally efficient. Nor are they expected to be efficient operationally either. As a result, it would be easy to dismiss the bond market’s unresponsiveness to the rise in inflation.

A better explanation, however, is that the Covid generation will pay exceptional prices for certainty. The Covid investors are predisposed to keep bond yields low even in the face of exceptional amounts of inflationary news. And they should adopt risk management procedures when they invest electronically as well as when they use an advisor.

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This article is not intended as investment, tax, or financial advice. Contact a licensed professional for advice concerning any specific situation.