Behavioral Economics: The Psychological Shifts Driving the Current Financial Ecosystem

Throughout 2020 and so far in 2021, consumers, investors, and politicians have attempted to navigate an unpredictable coronavirus pandemic, heated U.S. Presidential Election, and turbulent international relations. We saw in real-time the transformation of individual consumer decisions and the pre-pandemic status quos. Investors shifted to technology stocks, electric vehicle stocks, alternative clean energy stocks, and Special Purpose Acquisition Companies (SPACs). “Robinhood Investors” have become mainstream with Tik Tok, Facebook, Twitter, and other social media platforms driving “fad investing”, as we have seen with inflated campaigns to invest in Dogecoin and Nikola (prices quickly running up just for it to plummet back to normalized valuations). The main phenomenon driving Robinhood investors is groupthink and “fear of missing out” (FOMO) on potential rallies or downturns. Additionally, the façade of the Robinhood platform gamifies the investing experience, focusing more on day trading rather than long-term investing (as explained here).

 

Amid the retail investor’s increased market involvement, stocks have recovered from the March 2020 lows and have reached new all-time highs despite economic, policy, and societal headwinds. The steep upward trajectory of the stock market is not just a 2020 occurrence. Instead, the idea that “stocks only go up” started back in 2019 after a long period of low market volatility. However, questions regarding the longevity of the equity market rally plagued with inflated valuations have started to compound with one problem at doubt’s core: Is this stock market appreciation sustainable? 

 

Before we answer this question lurking in the back of many investors’ minds, we first must understand the behavioral economics or the psychology driving economic decision-making processes of individuals and institutions. As Herbert Simon said, “the phrase behavioral economics appears to be a pleonasm (redundant). What ‘non-behavioral economics’ can we contrast with it? The answer to this question is found in the specific assumptions about human behavior that are made in neo-classical economic theory.” The assumptions of neo-classical economics are optimization, self-interest, consumer sovereignty, and unbiased beliefs. Traditional neo-classical economists assume that people, given their preferences and constraints, can make “rational” decisions by effectively weighing each option’s costs and benefits. Therefore, people have self-control and remain unmoved by emotions and other external factors. If this is the case, then how do we explain the irrational investing decisions evident throughout 2020 and overflowing into the beginning of 2021. For instance. can neoclassical economics completely explain 2020’s steep equity selloffs, mortgage REIT dislocations, “Robinhood Investor” fads, stock overvaluations, political divisions, and COVID-19 reactions (individually, politically, and socially)? In short, no.

 

However, behavioral economics takes a different approach by drawing on both psychology and economics to explore why people sometimes make irrational decisions and why and how their behavior does not follow traditional economic predictions. It incorporates emotions, self-interest, overconfidence, loss aversion, and self-control. That is why over the past year, the notion of behavioral economics and behavioral finance has been at the forefront to define the novel term of 2020: “new normal.” The phrase “new normal” does not mean we live in a different reality, or this dynamic is like nothing we have ever experienced as a human race (the 1918 flu pandemic followed by the roaring 20s) because that would simply be misleading. Instead, pertaining to Matthew Rabin’s term “Explainawaytions”, a “new normal” illustrates that our baseline status quos have changed due to our excuse maintenance of the “normal” diverging. Applying this notion to the current situation, excuse consistency was forced to adapt to new restrictions, fears, and other unprecedented irregularities caused by COVID-19. As explained in the Deciphering a (COVID-19) Vaccine-Driven Economic Recovery: An Equity and Fixed Income Perspective, consumers shifted away from non-essential retailers, travel, hospitality, entertainment, airliners, and oil, spawning equity and bond selloffs (depressing their respective prices). Additionally, due to the high-profile pursuit to find a vaccine, biotechnology investors gambled for breakthroughs. Furthermore, these consumer demand downdrafts caused the demand pendulum to swing toward investors buying (and seeing excessive gains) technology, financials, SPACs, and disruptive industry companies. 

 

With this said, Daniel Kahneman and Amos Tversky’s noble prize-winning hypothesis, prospect theory, has been on full display with multiple exaggerated examples in different asset classes and sectors throughout 2020 and so far in 2021. The prospect theory utilizes the concept of loss aversion, an asymmetric form of risk aversion, from the observation that people react differently between potential losses and potential gains. In short, when people are faced with a risky choice leading to gains, individuals become risk-averse, preferring solutions that lead to a higher certainty (concave value function). Meanwhile, individuals faced with risky decisions leading to losses become risk-seeking, preferring solutions that have the potential to avoid losses (convex value function). 

Prospect theory has always had a concrete level of validity, but the economic dynamics of 2020 and so far in 2021 have displayed an increasing correlation to this notion. With this said, how do investors hedge themselves against the irrationality present in a post-COVID environment?

Though debate persists around quantifying irrationality and the derivative and second derivative effect from misinterpretation, an investor can hedge themselves from behavioral inconsistencies and investment misalignments by understanding the context and utilizing behavioral principles in investment decisions. For example, corporate insider buying can depict healthy, optimistic, and enthusiastic sentiment for a specific equity, which could be an excellent preliminary indicator to stock outperformance. Additionally, from a fixed income perspective, corporate insiders buying their company’s common stock historically experience lower default and bankruptcy rates, thus, providing an extra stress test on corporate bonds. Lastly, as described in Opportunities in the Corporate Buyback Environment, fundamentally sound corporate buyback allocation decisions can also depict increasingly optimistic corporate sentiment and potential for stock outperformance. All in all, the balance of neo-classical economics and behavioral economics have started to favor behavioral perspectives. Therefore, investors must remain cognizant about irregularities in the marketplace and capitalize on opportunities this “new dynamic” will likely continue to create. Sometimes capitalizing on behavioral dislocations is more efficient than rationalizing irrationality.

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Hunter Frey, Analyst
Hunter Frey, Analyst
Hunter Frey is an Analyst at Catalyst Capital Advisors, LLC and Rational Advisors Inc. covering all in-house equity strategies and an insider buying income-oriented strategy at Catalyst Funds. Mr. Frey received a Bachelor of Science degree in International Business with a focus in Spanish from Gardner-Webb University, Godbold School of Business, and is in pursuit of a Master of Business Administration in Economics and Finance from New York University, Stern School of Business.

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