Emotion, fear override rational investment plans
A mass shooting at a Las Vegas concert kills 58. Twenty-two people die in a mass shooting in El Paso, Texas. A church shooting here. Another mall shooting there. Terror strikes fear into our hearts and signals caution for investors.
Albert Wang, associate professor in Finance at the Harbert College of Business, discovered a $75.1 million drop in aggregate flows to equity (stock) funds—and a $56.8 million increase in safer government bonds—within one month of increased terrorist attacks in the United States over a six-year period.
Simply put, terror drives fear and fear drives what are perceived as safer investment decisions.
In his co-authored paper, “Terrorist Attacks and Investor Risk Preference: Evidence from Mutual Fund Flows,” Wang studied thousands of stocks and bonds funds to uncover the reactions directly following 409 attacks on US soil. The Department of Defense defines a terror attack as one in which the perpetrator or perpetrators had a political agenda.
“We used the number of attacks each month as our measure of terrorism because a single large attack might be seen by investors as random and have only an isolated effect,” adds Wang, who noted that most attacks had little to no impact on the stock market, except 9/11.
“We all have our levels of risk aversion,” Wang says. “There are psychological studies that show how these negative emotions—fear and anxiety—affect people’s general views of risk. Before the shock of a terror attack, one investor might think, ‘Oh, I can afford to lose 10 percent one day.’ After an attack, fear and anxiety make safety more valuable to you, and you say, ‘10 percent? I can’t live with that! The world is too dangerous now! I’ll switch to bonds, which are more appealing with less downside risk.’
“The whole point of switching from stocks to bonds is to escape to safe assets out of the anxiety and fear that you experienced after terrorist attacks.”
Though the transitions out of fear did nothing financially for investors, they were simply playing not to lose, according to Wang. “They aren’t thinking about the upside anymore,” he says. “They are thinking too much about the downside.
“Is this rational for investors to reduce their investments in stocks and move to government bonds? Is it because the stocks are going to perform worse? No. Is it because the government bonds are going to perform better? No. They do this out of the response to shock. Economically, there is no justification for doing this. But this study speaks to the remarkable influence of psychology on the behaviors of the investors, an area that is broadly defined as behavioral finance.
“We also found that after moving from stocks to bonds, within three to four weeks they go back to stocks. This is a short phenomenon of behavior. They thought they were protecting their investments.”