Lessons in Behavioral Bias: The COVID-19 Equity Markets

The stock markets over the last two years have been variously nerve-racking and exhilarating depending on who you ask and when.

But for behavioral finance aficionados, the COVID-19-era equity markets have offered a rare opportunity to witness an almost never-ending sequence of behavioral biases in action.

Indeed, we can draw straight lines from various market phenomena observed since March 2020 to specific behavioral biases and sets of biases.

Staying Away

One mistake investors made early in the pandemic was not buying quality names after the initial COVID-19 plunge. To be sure, cruise lines and other firms in the direct path of pandemic-related related disruption were going to be a hard sell, but many companies that experienced sharp corrections had long track records of highly profitable operations across multiple business cycles. They were cash-generating machines with strong balance sheets, powerful brands, wide and loyal customer bases, significant pricing power, wide moats, etc. The pandemic was not going to sink them. Demand was bound to recover.

So why did so many of us — including yours truly — hesitate and miss out on the opportunity of a lifetime? Because of a mix of the following biases:

Myopic Loss Aversion: We overfocused on short-term losses and underemphasized the potential for long-term gains. This led us to avoid assets that had experienced recent volatility. 

Continuation or Extrapolation Bias: This also played a role. Because we had just been on the volatility rollercoaster, we assumed the ride wasn’t over, that it would continue indefinitely into the future.

Regret Aversion: This was another key bias. We feared the consequences of errors of omission, of not buying the right stock, just as much as those of commission, or buying the wrong stock. So many of us stayed on the sideline.

Chasing Pandemic Winners

The massive monetary and fiscal stimulus that began in March 2020 combined with the work-from-home (WFH) phenomenon guaranteed that many stay-at-home stocks would become huge pandemic winners.

Despite the surge, however, many of these were absurdly priced loss-making companies even back in April 2020. It was also clear that demand was being pulled forward and that the stupendous revenue growth achieved during the pandemic was unsustainable in the medium to long term.

So why did so many of us jump on the bandwagon and refuse to get off?

Self-Enhancing Bias: Who deserves credit for our success? We do. If we bought Peloton and its price quadrupled in six months, it was because of our stock-picking genius rather than dumb luck or a market fueled by cheap money.

Herd Behavior: Much like a school of fish that swims in the same direction, we humans mimic the behavior of others. When in doubt, we go with the crowd in forming our opinions or making quick decisions. And that’s especially true in a bubble or crisis.

Confirmation Bias: We choose what information we consume about our decisions and we gravitate towards data that validates them. So we surround ourselves with people and media that tell us what we want to hear. From April to October 2020, financial news media trumpeted the pandemic winners, the Pelotons and the Zooms. A famous investment newsletter to which I subscribed wrote only about these sorts of stocks, talking up the positives and ignoring any negatives.

Missing the Clues on Inflation

Few expected inflation to soar so high or to stay high for so long.

We underestimated the magnitude of the splurge on consumer goods amid the lockdowns and overestimated the strength and resilience of global supply chains. And the demand and supply-side shocks drove inflation to 40-year highs.

Why did we miss the signals? Because inflation had barely budged in 10 years. Massive quantitative easing (QE) in the aftermath of the global financial crisis and record low unemployment had had little inflationary effect. Since inflation hadn’t increased in so long, we assumed it never would. If $4.5 trillion hadn’t done the trick, what was a few trillion more?

Availability Bias: That’s what behavioral economists call this. It comes down to the three Rs: We recall what’s recent and consider it relevant. The first two Rs are fine, but the last is a disaster. Many of us weren’t alive for the last stagflation, when interest rates hit 20% in the early 1980s, and know only the rather benign inflation that has been the story ever since Paul Volcker tamed the dragon back in 1982. So we believed the future would look like the recent past.

The Robinhood Effect

Remember the meme stock mania in early 2021? When Jim Cramer and company couldn’t stop talking about GameStop and Hertz and AMC? AMC shares jumped 250% in five trading days and GameStop’s shot from around $17 to $350 in January 2021.

The Wall Street Bets subreddit was largely responsible. The forum grew 400% in less than a week, from two million users to over eight million. Many forum members had never directly invested in the market before.

Stimulus checks had fattened bank accounts and we bid up these stocks to ridiculous levels. A few hedge funds had shorted some of them and many retail investors saw a chance to stick it to the big shots. Some hedge funds got caught in the ensuing short squeeze. But fast forward a few months and the meme stocks collapsed, leaving many investors with huge losses.

Herd Behavior: Again, we were following the crowd. Only this time, it was enhanced by a wave of social contagion.

Framing Bias: This was also at work. Investment decisions weren’t made based on facts, but on how information was presented or “framed.” The populist David vs. Goliath narrative of retail investors taking on the big-time hedge funds was too appealing for many to ignore.

Vaccine Skeptics

Vaccines take time to develop. Ten to 15 years was the benchmark pre-pandemic. Few expected COVID-19 vaccines less than a year after the first lockdowns. We anticipated the pandemic lasting much longer.

We didn’t see all the progress on the ground. Scientists had been studying coronaviruses for more than half a century. Medical technology had become so advanced and computers so powerful that genomic sequencing had uncovered the viral sequence of SARS-CoV-2 in lightning speed. 

Volunteers queued up and the clinical trials were rapidly completed. The US Food and Drug Administration (FDA) streamlined its approval process. Rather than the usual 10-month review process for a new drug, the FDA skipped the coronavirus vaccines to the front of the line. The Pfizer vaccine was reviewed and authorized for emergency us just 21 days after it was submitted.

Conservatism Bias: We favor pre-existing information over new data. This can make us slow to react to new and critical information.

Anchoring Bias: When making decisions we often concentrate our focus one one reference point. We over-rely on the very first piece of information we encounter. That can cement a narrative in our minds that we have a hard time breaking out of even in the face of newer and better data. With vaccines, we anchored on that extended vaccine development window.

Taking a Bath by Buying the Dip

Buy low and sell high. We all know the phrase. There were plenty of dips during the pandemic, and investors rushed to buy the falling stocks. But were they really good bargains? In a few cases maybe, but many were still priced at nosebleed levels based on the price-to-sales valuation metric, even after hefty declines.

By comparison, on the same date, the S&P 500 and the NASDAQ traded at price-to-sales ratios of 3.1 and 3.6, respectively. The rush to buy the dip is far less now.

Anchoring Bias: Once again this was the culprit. Investors were fixating on the higher, earlier price and hence jumped at the big percentage drop not realizing that something alarmingly expensive had become only slightly less so. Moreover, after realizing gains at a higher price, investors weren’t anxious to selling at a lower on.

Trusting the Fed

Inflation was supposed to be transitory. That’s what Jerome Powell and the US Federal Reserve told us. And we believed them, hook, line, and sinker. Turns out, the Fed was wrong and is now behind the curve. The probability of a hard landing is rising.

By my estimates, only once in the last 11 tightening periods has the Fed achieved a “perfect soft landing.” That’s an awful resume. And the Fed has never tightened into such a vortex before. Think about it: soaring inflation, an ugly war, supply chain disruptions, an ongoing pandemic, and a frothy, anxious stock market — it would be a difficult environment for even the most prescient forecaster. And let’s be honest, with its terrible track record, the Fed hardly fits that bill.

So why did we trust the Fed forecasts?

Authority Bias: The US psychologist Stanley Milgram popularized this term for the misplaced trust we place in formal authorities, “the experts.” We’re more likely to believe the information they give us. Plenty of characteristics enhance the authority bias. Finance is a male-dominated profession and gender can play a role. So, too, can race and ethnicity and educational background.

Watching Our Biases

The pandemic stock market was a veritable bias fest. But it was also a great laboratory experiment. The big lesson I’ve culled is that the more we eliminate biases from our investment process, the better our investment returns.

The question is: Will we learn from the pandemic stock market? Hopefully. But don’t bet on it. Our memories are alarmingly short. That’s why I find it helpful to keep a mistake diary to help remember the motivations and thought processes behind my investment decisions that didn’t pan out. Rest assured, my journal has gotten much, much longer since March 2020. But it is an invaluable resource, so I’ll be mulling over these biases for a long time. 

But then again, maybe that’s just another bias.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

Image credit: ©Getty Images/Nick Dolding

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