Human Irrationality, Threat Perception and Coronavirus Pandemic

As reflected in the reaction of Global Markets to Corona Virus’ threat to global economy, it is easy to see why sentiment is often much more powerful than facts alone. This is not just limited to markets however. Events which appeal to human emotions and our primitive instincts always have a disproportionate impact than what objective assessment would warrant. This is true for terrorist threats, fears of recession and how broad based the impact of negative events will in general be.

Over the years, many philosophers, psychologists, authors and scientists have spoken about this phenomenon where the impact of news flow of certain events immediately triggers a ‘survival reaction’ or ‘fight or flight’ response, or in market parlance, ‘greed or fear’ taking over rational investment decisions. In many of these areas, one of the most elegant explanations and lucid examples backed by years of research and experiments with large sample size have come from Daniel Kahneman.

In his book ‘Thinking, Fast and Slow’, Nobel laureate Kahneman has spoken at length about ‘Human Irrationality’ and the way the process of thinking gets influenced by quite unexpected factors. For example, when asked about ‘how much is the population of Romania’ or ‘what is the distance between Mars and Earth’, the answer gets influenced by the numbers you may have encountered immediately before you reply – if they were big or if they were small, it doesn’t matter if they were in an altogether different context. Of course, the assumption here is that one doesn’t know the exact answer and is making a guess.

“Thinking, Fast and Slow” is a very interesting book and, at the same time, full of surprises and full of results which one least expects and which go against conventional thinking. One of the biggest lessons from this book is at least an awareness of how much we think we know, but in reality, we don’t. The false sense of confidence we have about many of our ideas and our understanding keeps us away from actually questioning those assumptions.

There are many cognitive biases and many of them contribute to making markets inherently not rational is the classic efficient markets sense. Whether we call it sentiment or something else, it is the underlying basis for overreactions which we usually see in the markets. No doubt Corona Virus is a serious health issue for the global economy. But there is hardly any doubt that the fear of Corona Virus and continuous media coverage can lead to fear and panic and a more severe reaction than is actually warranted. But then who cares for survival rates and transmission rates when the only thing everyone is talking about is how many more countries found their first case and the number of new cases that have surfaced in already affected countries.

As of now, news flow and sentiment are more driven by big picture and less by the actual probability of an individual getting affected. It is hard to tell how long such overreaction will persist. Let us wait and watch because humans can be more irrational than can be discounted in financial models for the markets and, more importantly, they collectively can remain irrational for a long time. 

Research Team
EM Alpha LLC

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About EMAlpha:

EMAlpha, a data analytics and investment management firm focused on making Emerging Markets (EMs) accessible to global investors and unlocking EM investing using machines. EMAlpha’s focus is on Unstructured Data as the EMs are particularly susceptible to swings in news flow driven investor sentiment. We use thoroughly researched machine learning tools to track evolving sentiment specifically towards EMs and EMAlpha pays special attention to the timely measurement of news sentiment for investors as these markets can be finicky and sentiment can be capricious.Our team members have deep expertise in research and trading in multiple Emerging Markets and EMAlpha’s collaborative approach to combining machine learning tools with a fundamental approach help us understand these markets better.

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