The Hindu Business Line : Risk psychology and market crash

Many investors are still reeling from losses suffered due to the market crash a fortnight ago. One of our friends has cut all his positions and moved into cash. He fears that the market will crash again. His reaction is natural. Psychologists call it the “Availability Heuristics”. What is it?

It refers to our evaluation of the likelihood of an event on the basis of how quickly associations come to our mind.

In a party, an acquaintance tells you that being software professional poses health problems. You agree. Why? Two of your best friends are software professionals and both suffer from high blood pressure.

Your mind relates the statement to the associated knowledge. That is availability heuristics. Your conclusion could well be wrong. Your best friends may be suffering from high blood pressure for non-work-related reasons.

The dread factor

The term availability heuristics was coined by Daniel Kahneman, who pioneered the field of risk psychology. Psychologists have for long studied our risk behaviour and have concluded that we overestimate certain risks and underestimate others.

This depends on our fear levels or what psychologists call as the dread factor. The more we dread a particular event, the more we think that it is likely to happen.

We dread catastrophic events — ones that cause extensive damage — as they are more vivid and available. That is why you and I are anxious when there is a terrorist attack in a neighbouring city or community. We are not that bothered about climate change, which is gradual and abstract.

Equity prices

Our friend was suffering from such a bias. He was concerned with the speed with which equity prices were moving up. But he, like most others, pushed aside such fear and bought stocks, hoping to sell them at a higher price later. And, then, the market crashed. This created anxiety — that the market could crash again.

Psychologists contend that the dread factor and availability heuristics force us to make sub-optimal decisions. Cutting losses and moving entirely into cash may be one such decision.

(The author is a Chennai-based investment strategist.)

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