Beyond herd mentality in financial markets

With Covid-19 having turned everything upside down, the world is experiencing a period of heightened uncertainty. But global markets – after initially dropping – have risen to within reach of their pre-March levels; how do we explain that?

by Tarang Tuli and Subrato Banerjee
Beyond herd mentality in financial markets
Wildebeest undertake a great migration across the Masai Mara in east Africa. Photo: World Expeditions.

(ATF) Human beings have always shown a preference for certainty. This evolutionary conditioning makes it natural to seek answers that lead back to surer footing, whenever life becomes uncertain and laden with unknowns. Of course, the means of seeking those answers may range from science, to religion.

As Covid-19 turns everything upside down, the world is currently experiencing the highest ever levels of uncertainty.

With no vaccine in sight, what prevails is a general state of under-confidence culminating in a freefall of global financial markets. After all, equity investments are nothing but the act of placing bets on the future – and the future appears dreary and bleak at the moment.

In complete defiance, global financial markets – after initially dropping earlier in March 2020 – have risen back to somewhere within reach of their pre-March levels. This is despite the spiralling infection rates and the unrelenting death rates. Neither science, nor religion has been able to provide a plausible explanation so far.

As they often do, experts have scrambled to form theories to explain this unprecedented phenomenon.

One of them is, the advent of low-cost financing that is finding its way into the financial and housing markets.

Another theory claims that the rise in financial markets has been fuelled by select few mega-size stocks such as Amazon, Google, Facebook, etc, while the rest of the market is experiencing high volatility.

Yet another theory claims that the monetary and fiscal stimulus has propped investor sentiment, which has driven the rise in financial markets.

While all the above theories are credible in their own right, they do not explain the complete ignorance of fundamentals by the investors.

In fact, one may even claim that the recent investor behaviour flies in the face of rational choice theory, which assumes that individuals will always make rational, cautious and logical decisions.

Limited mental bandwidth

We propose a theory that unifies all of these, based on the idea of limited mental bandwidth (LMB) first proposed by Sendhil Mullainathan (University of Chicago) and Eldar Shafir (Princeton University).

The idea is simple – our actions depend on information that our minds can immediately process – and the latter is limited.

For instance, when we have to travel urgently for an official meeting, our brains are conditioned to create a tunnel of focus on the things that are deemed most important (carrying meeting briefs, booking a cab quickly etc), so that when we finally make it to the meeting on time, we realise that we have forgotten our wallet at home (something that fell out of the tunnel, although extremely important).

Now it is well-established that uncertainty tends to reduce the width of this tunnel, so that the mind can only process very limited information – think about why sportsmen are more likely to make mistakes when the pressure is too high. A financial decision maker with a mental bandwidth to focus only on stocks like Amazon and Google is unlikely to process the larger picture that facilitates rational decision-making.

In addition to the above, in order to truly understand investor behaviour, it is important to understand that this goes beyond the so-called herd behaviourand a fear of missing out on the market rally.

These patterns have been observed in the past, just before the stock market crashes of the Dot-com bubble in 2000 and the financial crisis in 2008. But neither of these saw an extended rally as being witnessed in today's scenario.

The key differentiating factor this time is the optimism around the temporariness of the ongoing Covid-19 pandemic, thanks to various sources of unverified media content that consume the investors’ mental bandwidth.

There are widespread expectations that the global economy will bounce back as soon as a vaccine is discovered.

Tunnel of focus

This is evident in the stock market gains with every news report that indicates promising vaccine trials – a tunnel of focus on short-term prospects tends to ignore possibilities of failure.

Irrespective of the rise in infection cases or the death rates, the optimism around the potential discovery of a vaccine is unlikely to die down.

The fiscal and monetary stimuli being injected by governments and central banks are further helping investors to hold-onto their optimism. Each investor’s mental bandwidth, therefore, focuses only on the optimism of the herd of fellow investors.

In our assessment, it will perhaps, take a significant trigger, such as the collapse of Bear Sterns in 2008, for investors to open their eyes to the strong headwinds in front of them.

For, irrespective of whether or not a vaccine is discovered, the global economy is clearly on a downward spiral.

As seen in the past, it is likely that investors will learn the hard way, the perils of seeing the world through rose-coloured glasses, for in the wise words of Ambrose Pierce, “Optimism – the doctrine or belief that everything is beautiful, including what is ugly.”

Subrato Banerjee is a behavioural scientist at the BEST centre, Queensland University of Technology, and an honorary fellow at the University of Melbourne.

Tarang Tuli is a seasoned workforce strategy professional, specialising in delivering global strategies to enable the future-proofing of skills, transformation of workforce and business outperformance.