Introduction
Behavioural finance is considered as a secondary field of behavioural economics that investigates the irrational behavior and cognitive psychology of investors and financial practitioners,which affects the investment returns and explains many empirical patterns (Ritter, 2003).This essay discusses how the recent worldwide outbreak of the Corona Virus affects the confirmation bias among investors throughout the world, thus opening the scope for potential equity stock mispricing.The predominance of confirmation bias among investors results in their overreaction, which negatively affects the stock prices listed on the stock market. Some ways to counter the confirmation bias while investors make investments in the equities listed on the stock market will be discussed, as well as the trading strategy which can be exploited amid the Corona Virus outbreak to create a better opportunity of investment and maximize the returns of investors.
Confirmation Bias and FearAffecting Public Equity Prices
First, a brief description of Confirmation bias will be demonstrated.Confirmation Bias is defined as the interpretation of thecontent in a way to support the investor’s own beliefs or arguments(Nickerson, 1998). Confirmation bias is perhaps the most well-known behavioral finance bias, which “acts like a compulsive yes-man who echoes whatever he wants to believe”(Zweig, 2009). The significant existence of the confirmation bias is recently proved quantitatively by Hart in the meta-analysis(William Hart, 2009). It is based on the assumption that agents will tend to accept the information that will be in line with their arguments, ignoring othercontradicting signals and, hence, validatingpredictions already drawn.The existence of investorswho are prone to confirmation bias causes significant price anomaliesfor holdings in financial markets(Pouget, 2011).
When uncertainty hits the market, the previously held complacencyamong investors is shattered and market individuals start thinking that the worst is yet to come. This is amplified by rumors and “scary” news, causing multiple waves of fear in the market.In the fear of the unknown,market participants start paying more attention to the negative signs,henceshiftingtheir moods into panic mode. According to confirmation bias, when new information arrives non-Bayesian agents will update their economic expectations in a manner to support their initial negative or positiveimpressions(Charness G., 2015). In the case of coronavirus, investorsoverweight the prospect of future negative shocks, as it is an event with huge emotional impact, fueled by a plethora of dramatic news about its consequences. Overreaction of investors due to their confirmed fear is supported also by Jeremy Warner in the Telegraph, who states that “Globalization in combination with social media amplifies wider economic consequences. There is nothing more contagious than fear”(Ameinfo, 2020).
In the past two months, the threat of coronavirus spreading across the globe reverberates across the market, amplified by the media hysteria, leading to fear-based overreactions among investors.The recent closure of the car plant manufacturer and quarantine of 10 towns in Italy in the middle of the Corona Virus outbreak have further increased the concerns of the investors. These events have made many traders around the globe believe that the massive selling of stocks is knocking at the door. Most investors are overreacting to the news and selling stocks at a rapid pace due to widespread uncertainty which is fueled by the news.On the 28th of February 2020, the US stock market drop to its worst record since the 2008 recession(Amber, 2020). S&P 500 declined around 13% on and FTSE 100 slumped by 3.5%and VIX index reacheda one-year pick at 25, making the last week of February the worst record of wealth shrinkage in the stock market(Wigglesworth R., 2020).This sentiment of investors will further decrease the value of stocks due to their confirmation bias as they extrapolate the consequences of Coronavirus more unfavorably than they are.However, the value of stocks is forward-looking, meaning that their value is determined by the value of economic activity in the long run and such a decline in major stock indexes should be verified by huge persistent losses in the long-term stream of corporate earnings.
The following chart reflects the equities slump on major worldwide indices.
Figure 1: S&P500 and MSCI Asia pacific presented in US dollars; Stoxx 600 in euros (Financial Times, 2020)
The recent outbreak of the Corona Virus has stumbled the worldwide stock markets amid its growing phase mainly driven by the rise in the tech stocks. Some of the investors have created a mindset that the outbreak will leave a long-lasting effect on the stock prices listed on the stock market. Investors lookout for the information that confirms their bias that the stock prices will decrease as the result of the worldwide outbreak of the Corona Virus.Furthermore, the regular media coverage of the disease and various reports add to the already created misconception of panic of the investors said, President Donald J. Trump.All this fear increases the panic of the general public and investors, who look out for further information that solidifies their already created belief of drowning global equity markets due to the impact of the newest type of Coronavirus. The constant increase in the panic and the easily available information through the media creates confirmation bias, which leads to an overreaction by investors in the markets, which have observed a massive dip in the recent two weeks. This will further decrease the prices of stocks due to the investor’s belief in the Corona Virus and its worldwide impact(NY Times, 2020).
On the other hand, several factors prove that the investor’s overblow corona Virus impacts. Historically, recent similar epidemics like SARS (813 deaths), MERS (36 deaths), Ebola(11.3K deaths), Swine flu (293K deaths) and Spanish Flu (50.0M deaths) had a temporary effect on markets, which were recovered soon after the breakout(Ameinfo, 2020).SARS outbreak in 2003 had a short term impact and markets had a 20.76% gain at the year-end, but still, many investors try to prove their point that Corona Virus will impact markets in more important terms which lead to thefrantic selling of stocks at lower prices(MarketWatch, 2020).Investors tend to overreact to the health threats due to which many of the investors leave the market, and the massive number of sellers decreases the share price of stocks. The experts believe that the impact of the Corona Virus will primarily affect worldwide traveling and spending patterns in Asia. Still, overall, the economic model will be short-lived, and markets will bounce back(Brush, 2020).
|
|||||
|
|||||
Figure 2…………………….
Meanwhile, constraints to arbitrage prevent rational traders and arbitrageurs to exploit the current market anomaly. Although there are behavioral traders, who trade on investor sentiment, it is controversial if they can force equity prices to their correct value(Dimitri Vayanos, 2010). Also, even if rational traders are aware of the undervalued stocks, they stay on the sidelines to “time the market” rather than correct them to their fundamentals, as a poor short-term performance leads to an outflow of funds(Schleifer Andrei, 1997). Mispricing in assets may persist for many months as arbitrageurs incur holding costs, “fundamental risk” and “synchronization risk” (Abreu Dilip, 2002). All the above factors cause rational traders to delay acting on the current information.
Trading Strategy
Investors need to look for all the favorable and unfavorable information for the particularclass of assets to make an impartial decision. Investors should double-check the data supporting their arguments to nullify the effect of confirmation bias. Detailed investment research helps investors make their position regarding the particular class of assets clear, and this process reduces the risk of confirmation bias to a significant level.The third-party suggestion could help investors to get confidence regarding their statements on their investments in equities(Mind Tools, 2018). Furthermore, investors can use the six thinking hats strategy while investing in the equities to minimize the risk of losing the money in investments due to the confirmation bias. Six thinking strategy involves analyzing and interpreting the situation from multiple perspectives to deal with the information regarding the equities in which the client has invested the money(Bono, 1985).
While majority of the investors are overreacting to the Corona Virus outbreak, leaving the stock markets by selling the stocks at significantly low prices, on the other hand, some investors can seize the opportunity available to them by purchasing the shares at the stock market at low prices and earn huge capital appreciations and dividends on the shares once the Corona Virus’s treatment is discovered and the disease is contained(Yahoo Finance, 2020). In a time of panic, a rational investor can devise an excellent trading strategy to earn huge profits by “buying the dip”. Investors need to think carefully regarding portfolio construction, which should be diversified rather than focusing on a single sector or single economy. A well-diversified, well researched and off course well-constructed portfolio by screening every stock carefully and then buying amid of Corona Virus outbreak when investors are leaving the markets by selling the shares at the rapid pace, can provide an enormous profit-making opportunity for any rationale investor to enter the market and earn huge returns in the long-term.
Conclusion
Incrux, it is generally believed that confirmation bias is very common among the investors which results in overreaction by the investors causing the major dip in the markets worldwide. As explained above, Corona Virus just like the previous diseases for example SARS has caused panic among investors. Media Hysteria has also contributed to the massive surge in the investor’s panic. Investors need to impartially confirm the news before taking investment decision and this uncertainty can act as the right time for new buyers to buy at a low price as the majority of the investors are selling stocks at below intrinsic prices.
References
Abreu Dilip, B. M. K., 2002. Synchronization Risk and delayed arbitrage. Journal of Financial Economics, pp. 341-360.
Amber, J., 2020. Buzzfeed.News. [Online]
Available at: https://www.buzzfeednews.com/article/amberjamieson/coronavirus-stock-market
[Accessed 3 March 2020].
Ameinfo, 2020. Ameinfo. [Online]
Available at: https://www.ameinfo.com/industry/healthcare/has-the-world-blown-this-coronavirus-outbreak-out-of-proportion
[Accessed 29 February 2020].
Badshah, W., 2016. Effect of Representativeness Bias on Investment Decision Making, Istanbul: Istanbul Sabahattin Zaim University.
Brush, M., 2020. 5 reasons coronavirus fears are overblown — and 14 stocks to buy now. [Online]
Available at: https://www.marketwatch.com/story/5-reasons-coronavirus-fears-are-overblown-and-14-stocks-to-buy-now-2020-01-28
[Accessed 02 March 2020].
Charness G., C. D., 2015. Confirmation bias with motivated beliefs. Games and Economic Behaviour, pp. 1-23.
FT Times, 2020. How the coronavirus shattered market complacency. [Online]
Available at: https://www.ft.com/content/a8fc2e2c-5a46-11ea-a528-dd0f971febbc
[Accessed 03 March 2020].
MarketWatch, 2020. How the stock market has performed during past viral outbreaks, as coronavirus spreads to Italy and Iran. [Online]
Available at: https://www.marketwatch.com/story/heres-how-the-stock-market-has-performed-during-past-viral-outbreaks-as-chinas-coronavirus-spreads-2020-01-22
[Accessed 01 March 2020].
Mind Tools, 2018. Avoiding Psychological Bias In Decision Making. [Online]
Available at: https://www.mindtools.com/pages/article/avoiding-psychological-bias.htm
[Accessed 03 March 2020].
Nickerson, R. S., 1998. Confirmation Bias: A Ubiquitous Phenomenon in Many Guises. Educational Publishing Foundation, Volume 2, pp. 175-220.
NY Times, 2020. The Coronavirus Is More Than a Disease. It’s a Test.. [Online]
Available at: https://www.nytimes.com/2020/02/25/opinion/coronavirus-cases-spread.html
[Accessed 03 March 2020].
Pouget, S., 2011. A Mind is a Terrible Thing to Change: s.l.: European Institute of Finance.
Reporters, F. T., 2020. Financial Times. [Online]
Available at: https://www.ft.com/content/5ec9aeae-56a1-11ea-a528-dd0f971febbc
[Accessed 28 February 2020].
Ritter, J. R., 2003. Behavioral Finance. Pacific-Basin Finance Journal, Volume 11, pp. 429-437.
Schleifer A., V. R., 1997. The limits of Arbitrage. The journal of finance, 52(1).
Wigglesworth R., M. K. S. T., 2020. Financial Times. [Online]
Available at: https://www.ft.com/content/a8fc2e2c-5a46-11ea-a528-dd0f971febbc
[Accessed 1 March 2020].
William Hart, D. A. A. H. E. I. B. M. J. L. L. M., 2009. Feeling Validated Versus Being Correct: A Meta-Analysis of Selective Exposure to Information. Psychol Bull, pp. 555-588.
Yahoo Finance, 2020. Is the Market overreacting to Corona Virus Outbreak? [Online]
Available at: https://finance.yahoo.com/news/is-the-stock-market-overreacting-to-coronavirus-172222574.html
[Accessed 03 March 2020].
Zweig, J., 2009. How to Ignore the Yes-Man in your head. The Wall Street Journal.
