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Crisis and confidence

Dave Fishwick, head of macro & equities investment at M&G Investments

The current post-crisis environment offers significant opportunities for investors who can recognise the effects human emotional responses can have on asset pricing, says Dave Fishwick, head of macro and equities investment at M&G Investments

Effects of human emotional responses on asset pricing

Looking around the investment landscape today, I see a pretty fertile environment for those who are able to recognise the very significant effect human emotional responses can have on asset pricing. In my view, behavioural influences always have a key role to play in financial markets but, when investors experience a shock as rattling as the 2008 financial crisis, we are reminded just how powerful this influence can be.

An emotional factor that has been particularly in evidence over the years since 2008 is the role of memory in investors’ pricing of risk. There were strong signs last year that risk appetite was returning as the global economy broadly continued to recover from the crisis.

“Ideas about investment risk may reflect individuals’ recent experience rather than an objective assessment of the facts.”

However, the equity market wobbles and strength of ‘safe-haven’ government bonds over the past few months – which defied predictions made by many observers at the start of the year – points to how fragile sentiment still is, and suggests to me that investors broadly remain deeply traumatised by the experience of 2008. This may present some compelling opportunities in a post-crisis world as this memory fades and risk inevitably re-prices over time.

As human beings, investors tend to be most aware of what we consider ‘known’ risks – the risks that are frequent and obvious. As such, ideas about investment risk may reflect individuals’ recent experience rather than an objective assessment of the facts. This can cause significant mispricing of assets, and subsequently interesting opportunities for those who are able to separate emotional influences from fundamental facts. 

In behavioural finance, ‘availability bias’ refers to the cognitive bias that causes individuals to think something is more common or likely than it really is, simply because it comes more easily to mind. This means, in forming new opinions, people tend to heavily weight their decisions to more recent information or experiences – particularly when these events have provoked a strong emotional reaction. 

In investing, this can prove problematic. Availability bias pushes us towards the here and now, rather than making us look deeper. It may cause investors to become too caught up in the short term and make judgements based on emotional responses. I feel it is vital to maintain a sense of perspective and carefully consider the true significance of an event in a longer-term, fact-based context.

The short-termism encouraged by availability bias has important implications for our approach to investment risk. For all the known ‘available’ risks, there will always be a great many more ‘unavailable’ or unknown risks. So, it is important not to overestimate how much we can know about the future, based simply on what we remember most vividly about the recent past. It is vital to maintain a sense of perspective and carefully consider the true significance of an event in a longer-term, fact-based context.

Some of the best opportunities in terms of asset allocation may follow a genuine market shock. This is because ‘availability’ changes – think about how you temporarily slow down after witnessing a car crash, even though your own likelihood of crashing is no higher than before, and then return to normal speed as the memory of the shock fades. 

After a market shock, investors are suddenly more aware of particular risks – not because these risks did not exist previously, but because we have just been reminded of them. Subsequently, the risk premium on an asset rises – often just as we are doing everything we can to reduce that risk. However, over time, memory of the shock fades to be replaced by more recent memories and available risk changes, which can cause the risk premium on the asset that experienced the shock to compress. 

If we looked back at the subjects that have dominated financial news headlines so far over the course of this year, we would see how rapidly one concern has replaced another from week-to-week – emerging markets, Ukraine, tapering – as new topics arose, others faded into the background, regardless of whether they had been resolved. This shows how short human attention spans generally are.

In making long-term investment decisions, it is important not to confuse risk with volatility. As long as fundamentals do not change, we should maintain focus on backing our long-term convictions even when it feels uncomfortable to do so in the face of short-term shocks. In this way, we should give ourselves the best chance of being on the right side of things as risk re-prices.

Table 1: Outperformance of equities v bonds since 2004
Source: Datastream, as at 31 December 2013

In Table 1 on the right, we can see the dramatic impact of shorter-term market shocks on global equity prices over the past decade. In the years immediately preceding 2008, investors seemed to have become very comfortable with holding equities on the back of a fairly sustained period of strong performance.

The shock of the 2008 financial crisis saw widespread panic-selling of equities. However, in time, the memory of the shock began to fade and equities gained in popularity again – until the next shock. In the past year or so, equities have largely re-rated once more, as risk premia have materially reduced.

Global bonds have experienced significantly less volatility over the same period but the real risk in holding bonds instead of equities over the past decade has been the opportunity cost of missing out on the significant outperformance of equities. In my view, the most favourable investment outcome would have come from a well-diversified portfolio, in which bond holdings would have made short-term equity volatility more tolerable in the pursuit of long-term objectives.

Investing in peripheral European assets in recent years is a good example of this. The eurozone crisis dominated headlines and, although Europe’s problems were and are very real, emotional drivers have appeared to make people overreact. This has created the opportunity for strong subsequent returns in equities and bonds in the periphery as earnings remain depressed and several peripheral countries have begun taking some steps towards structural reform.

Table 2: Italian Shiller P/E – Cheap valuation on depressed earnings, scope for recovery
Source: Datastream, as at 15/01/14

Table 2 on the right shows the cyclically adjusted price-to-earnings (P/E) ratio – or Shiller P/E – of the Italian market from the end of 1997 to the end of 2013. It shows quite clearly the cheap valuation on offer amid depressed earnings and the potential for investors once earnings recover and markets re-price.

Another interesting current example of availability bias causing pricing to be at odds with the facts is cheap valuations in the US banking sector (see Table 3 below). But are banks any more risky today than pre-2008? Concerns cited about banks tend to centre on them being too big, badly regulated and irresponsibly managed.

These may or may not be valid concerns but are they any more true today than 10 years ago? In fact, it is probably the case that these issues are now being addressed to some extent. So why should banks be so much cheaper today? And as the memory of the shock of 2008 eventually fades, might we expect a re-pricing of this risk which represents an opportunity in the sector at present?

As human beings, investors tend to be naturally averse to uncertainty, but we must admit that the recent past does not tell us very much about the future. When investors begin to overvalue ‘certainty’ and consider an asset to be ‘risk-free’, it is often at its riskiest. Conversely, when the consensus is overly fearful and demanding too much compensation for holding an asset that has recently underperformed, compelling investment opportunities may present themselves.

It is very important not to confuse our emotions with knowledge. Just because a recent experience may make it feel more comfortable to stay in ‘safe’ assets or pile into ‘risk’ assets, it does not mean investors know anything about how these assets are going to perform. Therefore, in making investment decisions, I believe it is important not only to understand the facts about different assets in the current economic context, but also to understand our own – and other people’s – emotional impulses.

Table 3: Are banks more risky today than they were?
US Financials Delivered Earnings ($) US Financials P/B x times
Source: Datastream, 17/03/14


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