How Fear Drives Market Behavior

In the realm of behavioral finance, few concepts have had as profound an impact on our understanding of investor psychology as prospect theory. Developed by psychologists Daniel Kahneman and Amos Tversky in 1979, prospect theory provides crucial insights into how individuals make decisions under uncertainty, particularly in financial contexts.

At the heart of prospect theory lies the concept of loss aversion, which posits that the pain of losing is psychologically about twice as powerful as the pleasure of gaining. This asymmetry in how we perceive gains and losses has significant implications for financial decision-making and collective human behavior driving markets.

Loss aversion manifests in several ways:

• Traders tend to hold onto losing stocks too long, hoping to break even.
• Traders may take on excessive risk to recover losses, potentially leading to even greater losses.
• Market participants often overreact to negative news, causing disproportionate sell-offs.

There are different theories as to why we, as humans, are inherently loss averse, the most prevalent of which are evolutionary and biological in nature.

Evolutionary psychologists argue that there’s an adaptive benefit to being loss averse; after all, you’re more likely to survive if you end up with lesser gains than you are if you lose until you’re left with nothing at all.

There are different theories as to why humans are inherently loss averse, with the most prevalent being evolutionary and biological in nature. Evolutionary psychologists argue that there’s an adaptive benefit to being loss averse; after all, you’re more likely to survive if you end up with lesser gains than you are if you lose until you’re left with nothing at all. For primitive humans, this tendency was crucial for survival. In a world where resources were scarce and losing what little one had could mean life or death, being cautious about potential losses was an advantageous trait. Avoiding risky situations that could lead to significant losses helped our ancestors preserve their resources and, ultimately, their lives.

However, in modern times, this ingrained tendency creates disadvantages across various aspects of life. Today, loss aversion can lead individuals to make irrational decisions, such as clinging to unfulfilling relationships or jobs out of fear of losing what they have, or taking excessive risks to avoid perceived losses in social status or personal achievements. This behavior can result in even greater setbacks and missed opportunities for growth and fulfillment.

Lets take a look at a couple of practical experiments that demonstrate loss aversion in practice.

Gambling

In their paper on prospect theory, Kahneman and Tversky conducted experiments to observe decision-making behaviors under risk. Participants were asked to choose between different financial scenarios.

In one scenario, participants imagined receiving 1,000 ILS (Israeli currency) and had to decide between:

• A 50% chance to win an additional 1,000 ILS, or
• A guaranteed gain of 500 ILS

A significant majority, 84%, opted for the certain gain of 500 ILS.

In another scenario, participants imagined receiving 2,000 ILS and had to choose between:

• A 50% chance to lose 1,000 ILS, or
• A definite loss of 500 ILS

Here, 69% chose the gamble to avoid the certain loss.

These results are intriguing because both scenarios present the same expected outcomes relative to the starting amount; the difference lies in framing one as a gain and the other as a loss.

This highlights loss aversion: people are more inclined to take risks to avoid losses than to achieve gains.

The Asian Disease Problem

The Asian Disease Problem is a well-known thought experiment in decision theory and behavioral economics. It was introduced by Tversky and Kahneman in 1981 to demonstrate how the framing of options can significantly influence decision-making, even when the outcomes are identical. The problem is typically presented as follows: Imagine that the U.S. is preparing for the outbreak of an unusual Asian disease, which is expected to kill 600 people. Two alternative programs to combat the disease have been proposed. Assume that the exact scientific estimates of the consequences of the programs are as follows: Program A: 200 people will be saved. Program B: There is a 1/3 probability that 600 people will be saved, and a 2/3 probability that no people will be saved. In a second version of the problem, the same scenario is presented but with different framing: Program C: 400 people will die. Program D: There is a 1/3 probability that nobody will die, and a 2/3 probability that 600 people will die. The key insight of this problem is that Programs A and C are identical in their outcomes, as are Programs B and D. However, when presented with the first set of options (A and B), a majority of people tend to choose Program A, preferring the certain outcome. When presented with the second set (C and D), most people choose Program D, preferring to take a risk to avoid the certain loss of life. This demonstrates how the framing of options in terms of gains (lives saved) or losses (deaths) can significantly impact decision-making, even when the actual outcomes are the same. This is again another example of loss aversion at play.

I find loss aversion very interesting in the context of trading. Trading should be about putting ourselves in a position to rationally maximize profit. However, due to loss aversion, humans tend to be hardwired to do the opposite and often become less rational when facing the prospect of loss. Basically, we are naturally wired to be terrible traders!

That’s enough of the background psychological theory. Let’s now move on to recent news events and data that demonstrates the irrationality that a herd of humans tends to display when experiencing fear in financial markets.

Examples of Market Reactions

Below are three noteworthy market events from 2023. Please do not base any trading strategy on the scenarios I highlight here next. These are cherry-picked events that show how markets overreact in the short term, providing potential opportunities for profit. Of course, it doesn’t always work out this way.

Headlines for March 7-10 2023

“U.S. stocks closed sharply lower on Tuesday as investors digested Fed Chair Jerome Powell’s hawkish comments that the central bank may need to continue with its steep rate hikes for a longer period than expected in order to control soaring inflation. Powell’s message ignited fears of a larger interest rate hike in the Fed’s next policy meeting. All three major indexes ended in negative territory.”

“U.S. stock markets closed sharply lower on Friday following the collapse of the biggest regional bank since the days of the great recession. The news had a contagion effect on the entire equity markets as investors remained extremely concerned that rigorous rate hike by the Fed in order to combat a record high inflation may result in a near term recession”

During this period, we saw the S&P 500 declined sharply by 5% over 4 trading days. Remember, all Jerome Powell said at this stage was that they may need to increase rates for longer than initially intended. Nothing had actually changed at this point. On 10th March It surfaced that Silicon Valley Bank was in distress and needed to raise capital to fulfil its deposit obligations to its customers. This sparked memories of the 2008 global financial crisis and fear a wider banking crisis was coming.

I’m not suggesting for one moment that higher rates aren’t generally a headwind for the stock market or that that failure of a regional US bank isn’t a negative outcome, but when I see such a negative move in a short period, I see fear and short-term opportunity for traders.

5 trading days later: +1.48%

10 trading days later: +2.83%

Headlines for May 2-4 2023

“Wall Street closed sharply lower on Tuesday as the regional banking crisis deepened. The possibility of a U.S. debt default raised concerns about the state of the economy, and oil prices sank. All three major indexes ended firmly in the red.”

During this period, there was political infighting in the US over raising the debt ceiling to prevent a government default. First Republic Bank faced a fate similar to that of Silicon Valley Bank and was taken over by regulators and sold to JPMorgan Chase & Co. The market declined 2.69% over three trading days.

5 trading days later: +2.02%

10 trading days later: +3.65%

Headlines for Oct 18-27 2023

“Wall Street closed sharply lower on Wednesday following a surge in yields of U.S. government bonds. Investors remained concerned that the Fed will continue to pursue tight monetary control for a long period. Moreover, intensified geopolitical conflict in the Middle East dented market participants’ confidence on risky assets like equities.”

“Wall Street closed sharply lower on Thursday, pulled down by tech and related stocks. Disappointing numbers coming in from big-tech earnings weighed on the market.”

Earlier in October, Hamas and several other Palestinian militant groups launched coordinated armed incursions from the Gaza Strip into southern Israel, sparking fears of a regional conflict in the Middle East and putting investors on edge. The news headlines were also negative about big-tech earnings; however, interestingly, Microsoft, Google, and Amazon’s earnings results at this time all exceeded analysts’ expectations. The market declined 5.33% over 8 trading days.

5 trading days later: +6.25%

10 trading days later: +7.63%

The study of loss aversion and its effect on financial markets reveals a fundamental aspect of human psychology that causes irrational trading behavior. By understanding how loss aversion affects decisions, traders can better understand themselves and the markets, potentially benefiting from the short-term overreactions that occur during times of uncertainty and fear. Recognizing these patterns is key to creating strategies that exploit the natural tendencies of market participants, offering chances for profit while maintaining a rational and strategic approach for yourself.