No forecasting model can show what happens when half of the world’s population is locked down for an indeterminate period. This sudden realisation of how little we know has been part of the reason for the plunge in stock markets since March. But more than simple fear lies behind the reaction from investors since the start of the year. Several psychological biases, largely undetected, have also been at work.
Too much confidence is one. Hyman Minsky, the famed American economist, argued that stability itself can spawn instability by encouraging investors to take excessive risks. As such, the extreme market reaction to coronavirus was a “Minsky moment” following a decade of decreasing equity-market volatility.
Which brings us to a second type of harmful psychological bias. In the weeks after the virus first hit China in late 2019, few in the west were too concerned. This negligence was understandable, given the geographic distance, but it reflected the assumption that the world is made up of separate populations with distinct or opposing concerns and interests.
This “in-group bias” led Europeans to be unruffled by the events in Hubei province and later prompted Donald Trump, the US president, to claim that the epicentre of the epidemic had shifted to Europe. Everyone knows that, by definition, epidemics spread — particularly in a world so interlinked. But psychological bias overtook that awareness.
Then we have insufficient understanding of geometric progression — where numbers increase by a ratio — as opposed to arithmetic progression, where they increase by a certain amount. If something is increasing by 25 per cent a day the number will triple every five days. Humans struggle to conceptualise that.
This may be why most observers, investors included, underestimated the speed with which the disease was spreading and failed to take timely action. Once they realised how behind they were, they panicked.
A final bias has contributed to the dramatic economic fallout the pandemic will produce — and to the recent equity-market weakness. This is the trouble we have in dealing with statistically abnormal risks.
The human mind tends to assess events in probabilistic terms: we seek to anticipate the most likely scenario and then determine a reasonable confidence around that scenario. It follows that what has never occurred before, or what is a statistical outlier, can usually be safely ignored.
The trouble is that such an approach disregards abnormal events that very rarely occur — but that change everything when they do. That explains why the city of Pompeii was established at what was thought to be a safe distance from Vesuvius, a long-dormant volcano; or why Japan built nuclear power plants on its coast, confident that protective walls were high enough to contain anything like the tsunamis the country had infrequently experienced in the past.
This disregard for black swans — unpredictable, high-impact events — has always been around. But modern society’s quest for optimisation has reinforced it. Building higher walls than had ever been needed before on the east coast of Japan, to achieve a large margin of safety, was not considered optimal. Similar criticisms are levelled at the high cost of managing global warming.
Likewise, duplicating supply chains or refraining from taking on debt despite rock-bottom interest rates over the past 10 years was not economically optimal behaviour. Those choices would have made systems less fragile, but also less productive.
Top-level athletes are extraordinarily strong, but also prone to injury. Racing cars are finely tuned for performance, but fragile to any unexpected force. There is a direct connection between optimisation and fragility. The inherent fragility of financial markets — which is the trade-off for the remarkable performance they enjoyed in the past decade as a result of unconventional monetary policy — goes a long way to explaining why they caved in so readily to the coronavirus shock.
It is human nature to seek insurance after a disaster hits. This means that consumers, investors, businesses and governments will probably emerge from the current crisis with a more clearheaded statistical approach to risk management for the years to come.
But if this is followed through, the tendency will be for household savings to increase, low-cost manufacturing to be on-shored and financial leverage to go out of fashion. Perhaps this will put economies on a more secure footing, but growth will be slower, companies less profitable and equity-market performance less stellar. In other words, more robust and less optimal.
The writer is a member of the strategic investment committee at Carmignac, the Paris-based asset manager
Source: Economy - ft.com
