Human Nature & the Stock Market

By Charlotte Service

The London Stock Exchange experienced its second largest one-day crash on the 12th of March 2020, falling by “more than 10% in its worst day since 1987”. The combined effect of pandemic-induced uncertainty and the fear of forthcoming economic turmoil led to widespread panic among investors. Shareholders began selling their shares as prices plummeted and record numbers of trades were carried out in the days following the imposition of the national lockdown. Yet, with share prices at rock bottom, investors were presented with a rare opportunity to purchase stocks at discounted rates.

After the crash, London’s market stocks were left trading cheaply across all sectors. It appeared inevitable that the earnings of most businesses were set to fall dramatically in the coming months. Given that travel, in particular, had been brought to a halt by the pandemic, it was logical that shares in airline companies were some of the most severely affected. However, it wasn’t just companies fated to be damaged by coronavirus that saw the price of their shares fall. Shares in Premier Foods Group, producer of familiar brand favourites such as Mr Kipling cakes, were already considerably low-priced prior to the pandemic but saw the value of their shares drop even further in March. Yet, the company was almost guaranteed to benefit from the restrictions implemented by the government – with eating out no longer an option for consumers, the demand for Premier’s products surged during lockdown. By November, the group’s share price had “nearly quadrupled since March”. Gas and electricity provider SSE too saw their share price collapse which appeared equally illogical, considering the long-term demand for energy wasn’t likely to change significantly. The price of shares in AstraZeneca also dropped dramatically as the lockdown was implemented, losing 10 percent of their value in just 10 days. Nevertheless, given that coronavirus was a public health issue, it would have been reasonable to suspect that a pharmaceutical company such as AstraZeneca did have the potential to prosper during the pandemic. 

Given investor decisions to part with shares in companies such as those discussed above, it becomes clear that logical reasoning wasn’t the fundamental catalyst for the resulting bear market. For the most part, people are better off holding onto shares during a crash, but such a decision requires people to follow their reason – something of which people generally lack when there is an end of the world mentality around. As the market went down in March, it became quite psychologically difficult for panicked investors not to sell their shares, let alone consider buying more. The adverse conditions of the virus gave rise to the natural fight-or-flight instinct in investors and it was this emotional response that provoked them to capitulate rather than pursue logical decision-making.

The tale of the Rothschild banking dynasty is a good example of how an awareness of this investor psychology can lead to profit when it comes to the stock market. The Rothschilds were a powerful and wealthy family known for their quick access to intelligence and reliable communications network across Europe during the Napoleonic wars. According to historical accounts, the family’s network of agents allowed them to discover the outcome of the Battle of Waterloo much before anyone else. Counting on the emotional response of their fellow investors, they enacted a plan which would even further enhance their wealth; in abruptly starting to sell large amounts of shares on the stock market, the Rothschilds led people to falsely assume the battle had been lost. As panic set in, investors began to frantically sell and the market crashed, allowing the Rothschilds to rebuy shares at a fraction of their original price. Of course, when it was revealed that the Battle had in fact been won, the stock market shot back up again.

The momentary stock market crash in the aftermath of 9/11 is a more recent example of human emotions at play when it comes to trading. The terrorist attacks evoked a similar reaction in investors as covid-19; panic driven sales in anticipation of market unrest saw the “S&P 500 fall more than 14%” in the subsequent week of the attacks. Despite such a drastic crash, the American stock market did recover quickly, returning to pre-9/11 price levels within a month of the incident. 

Both of the above accounts highlight the influential capacity of human emotion when it comes to the stock market, but they also demonstrate that markets have always recovered. A crash can be an opportunity for level-headed investors to buy shares inexpensively – if shareholders were able act of their own accord in March and look beyond the bad news, it may have led them to considerable financial gains. 

Despite this, it not necessarily the case that any currently low-priced stock is destined to go up in price. Low value shares may have long-term structural threats, meaning they are cheap for a reason. There are many businesses that may have the potential to earn short-term success, but this doesn’t guarantee them long-term desirability. The future of retail, for example, is particularly uncertain at the moment; many people have become so accustomed to online shopping over the past year that they may never return to the high street. Similar things could be said for the cinema industry, as questions arise as to whether people will be willing to spend money on the big screen when they can watch the likes of Netflix from the comfort of their own home. 

Like all emotions, panic is short-lived, which is perhaps why the stock market has undergone a particularly remarkable recovery in recent months. After the crash, as the reality of lockdown began to settle in, investors began to relax and think more rationally about the situation. The prospects of a vaccine brought much more optimism for the future, a set of more positive emotions which was reflected in the market. 

Despite this recovery, the volatile nature of the stock market has rarely been more visible than in late January. Until recently, American video game retailer GameStop was considered a particularly exhausted and unprosperous business, a fact which prompted many large investors to bet against the longevity of the chain. However, the mass collaboration of amateur investors in attempts to wager against greedy Wall Street hedge funds has seen GameStop reach a “$28bn or so market capitalisation that exceeded Halliburton, Kellogg and about half the companies on the S&P 500” within the past month. In driving up the value of shares in the company, the mob of day traders left short sellers with little choice but to buy back shares, accelerating the growth rate of the already rising prices. Originating from an online ‘Reddit’ forum, the trading phenomenon was already heavily trending on social media, and it wasn’t long before the buying frenzy caught on with the rest of the world. The concept of retaliating against seemingly exploitative major league investors appealed to many and fuelled frantic trading activity as small-time investors attempted to mirror the short squeeze with “some European stock being touted ‘as the next GameStop’ among retail investors”. There may be legitimate reasons behind the newfound success of GameStop, such as the arrival of new board members and the promise of future demand for physical purchases of video games, but such a drastic increase in the value of the company’s shares is primarily a consequence of speculation and investor excitement. The recent price fluctuations in GameStop’s share values have been rather erratic and regardless the hype, the market highs were never likely to last; already the value of the shares have started to fall back down to more pragmatic levels. In spite of this, given that it is reasonable to presume the extravagant price of shares in GameStop do not accurately correspond to the real value of the company, it stands to reason that the irrational exuberance of investors clearly plays a major role in undermining the functionality of the stock market. 

In the case of the bear market, it was an opportunity for smart investors to make the most of the low-priced stock; shareholders merely needed to contain their emotions and remain level-headed in order to establish a potential for substantial wealth creation. In some cases, all investors had to do make money last year was avoid the urge to panic and sell – behaviour which would have prevented the irrational tumble in stock prices of soon to be booming companies. For instance, if an investor had bought shares in Premier Foods on the first trading day of 2020 and then sold in March, they would have made a loss of over 50%. However, if they had chosen to hold onto those same shares until the last trading day of 2020, they would have made a profit of over 250%. Moreover, if an investor had remained composed and acted shrewdly as the market fell, they may have recognised the opportunity to buy Premier Foods’ shares extremely cheaply; had shares in the group been purchased on the 16th March, they would be worth nearly five times as much today. In other words, aloof investors with the ability to subdue their natural instincts during times of crisis are those with the potential to realise the most lucrative of investments. Indeed, investors who succeed in suppressing their irrational desires not only protect their financial position but can bolster the very functionality of the stock market in the process.

“The views expressed in this article are the author’s own and may not reflect the opinions of The St Andrews Economist.”

Image source: Investopedia

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