"The only thing we have to fear is fear itself"

mar. 13, 2020

This quote - taken from Franklin D. Roosevelt’s famous 1933 inauguration speech – is at least as relevant today as it was 90 years ago. In the 1930’s, it was essential to fight depression and to stimulate the US economy with (now) fairly standard fiscal tools after the Great Depression. But the real genius of his speech was to acknowledge the importance of boosting confidence and calming markets.

Why is this so important? Worrying about catastrophic events has been an essential feature of human behavior throughout history. Some even argue it is a behavioral trait that has been pre-programmed into us by evolutionary forces.

Nobel prize laureate Daniel Kahneman and Amos Tversky formalized this in their seminal paper “Cumulative Prospect Theory.” The idea is that people assign decision-weights to outcomes. Extreme and rare outcomes have larger “psychological” weights than common events. This is not the same as just getting the calculation of outcomes with small probabilities wrong: people do that too. Rather, decision-weights reflects the psychological perception of these extreme events occurring.

When I teach this in class, I usually present lotteries with the same expected outcomes and ask how attractive they are for my students. Suppose you could win $0 with 90% probability and $10 with 10% probability and think of a price you are willing to buy that lottery ticket. Most people would pay something in the range of 50 cents to a dollar (which is the expected value of the gamble). Now change the lottery: suppose you can win $0 with 99.99% probability and $100,000 with 0.01% chance. This has the same expected value, but people are usually willing to pay more, not less, even if the risk is higher and the utility of the marginal dollar should decrease across the two payoffs. People confound pay-offs and probabilities, which is an explanation why we see them both participating in different forms of gambling (to obtain gains), and yet pay for insurance policies (to avoid losses) at the same time.

This causes people to overreact to unlikely events. And this is exactly what is happening now. Surely, a massive outbreak of the Corona-virus could have very bad consequences for public health, and will be especially dangerous for vulnerable populations. This is a major medical risk. But the very fear itself of an outbreak can have terrible consequences for the economy. Shutting down workplaces, schools and airports clearly has a negative impact on the economy in the short run, but in the medium term, they sow fear, which amplifies the problem because we have to start second-guessing what other people will do and adjust our behavior accordingly. Why rush out and buy canned soup? Not because you actually want or need it today, but because everyone else is rushing out. Thus, if you don’t also rush out today, there will be none left for you tomorrow when you need it.

As a behavioral financial economist, I have learned two basic things. One is not to take normative finance too literally, and the second is to respect the force of psychology in financial markets. Does this help me in my own personal financial decision-making, you may ask? Obviously, if I knew how to make lots of money from it, I would not be in academia. In fact, I think there is no credible way for anyone to say how much the stock market should go down - or up for that matter - in the short run. But it does provide me with a sense of comfort that I do believe that markets (that is – you and me) sometimes overreact to extreme events. And if more people would listen to Franklin D. Roosevelt’s words, maybe we would be able to quell the sense of panic that currently grips us. After all, we’re human beings – we will survive!