Past Trauma Blinds Investors to Present Danger

The "Recency Effect" triggers loss aversion, even when the threat is misidentified.

Still fighting old wars.

H.F. Davis.Topical Press Agency/Getty Images

The CFA Institute published its annual sentiment report this week. It surveys individual and institutional investors to determine what they are anxious about.

You might be surprised to learn that about one-in-three is greatly concerned about another 2008-09 type financial crisis:

Investors revealed a growing anxiety about the state of global finance. Almost one-third of investors feel that another financial crisis is likely within the next three years (33 percent of retail investors/29 percent of institutional investors).

In some countries, such as India (59 percent) and France (46 percent), the fear factor was even greater.

Just as every general fights the last war, investors, too, fear what just happened. Rarely (if ever) are they concerned about the unknowns that might be ahead. We even discussed this last year in “what just happened versus what happens next.” It is simply part of investor psychology.

Why is this? The “Recency Effect” affects investors even more than it does generals and others. Loss aversion is based upon how much more painfully and deeply investors experience a financial decline versus the more modest impact of the positive emotions associated with a gain. As we learned from Daniel Kahneman and Amos Tversky, it's not that we don’t like to make money in the markets -- of course, we do -- it's just that the pain of loss is twice as strong as the pleasure of gains.

As noted previously, “Trauma may be the key to understanding investment-related recency effects. In investing, it isn't just the most recent events that stand out; it's events of greater psychological or emotional weight that leave the more lasting mark.”

Investors recall intense memories more than run-of-the-mill recollections, because, well, it's a good survival feature. An experience that put your life at risk -- and that you were fortunate enough to survive -- is going to leave a mark. Hence, an ordinary Tuesday has almost no resonance to your future investing self, but a market crash, a financial crisis, deep bear market or hyperinflation stay with investors for a long time.

When you look at the typical doomsayers --  those who capture the media attention -- they are not forecasting something unique: They are prognosticating a repeat of a prior catastrophe. (A variation of this is the folks who insist that the last crisis never ended). That sort of fear-mongering has much more resonance than warnings about something that hasn't happened before. Perhaps this helps explain why warnings about subprime and derivatives were mostly ignored in 2005-07.

How realistic are fears of a “do-over?” How often do we have repeats of recent crises? The double-dip recession of 1980 and 1982 are an OK example, but not a great one. Inflation, a 16-year bear market and the death of equities led to price/earnings ratios in the single digits by the time those contractions came along. Incidentally, that was a fabulous time to start buying stocks.

Hence, we end up with an understandable but somewhat irrational fear of what already occurred and not what might come in the future.

Long-Term Capital Management’s catastrophe -- a highly leveraged hedge fund trading illiquid securities -- was a forewarning about risk management and ramping up capital 40-to-1 times. But it hardly was a prescient warning about securitized subprime loans and derivatives.

I bet you can guess most of the people behind the following imminent anxiety-inducing claims:

  • Automobile credit as the new subprime.
  • 1987-like crash
  • Collapse of the dollar
  • Hyperinflation
  • Secular stagnation

The CFA Institute found that retail investors were most fearful of another financial crisis -- but they just barely edged out institutional investors (33 percent to 29 percent). It seems that anyone with a psyche is subject to irrational fears of a repeat of recent events. Investors should be looking forward, but too often are not.

What is it you are afraid of? If you are going to be fearful, at least be afraid of the right things.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.