The impact of the COVID-19 pandemic on the global economy is vast and profound. A recent study by Sima Ohadi, Co-Founder and Chief Behavioral Officer at OdonaTech, and Luc Meunier, Co-Founder and Professor of Finance at ESSCA School of Management, published in Economics Bulletin, explores how individuals' risk and time preferences changed before and one year after the first wave of COVID.
The COVID-19 pandemic has had extensive and profound consequences on the economy and financial sector, raising numerous questions. The confinement has clearly set us on a path toward a recession, and a key question in financial behavior analysis is whether this situation will alter individuals' risk-taking behavior.
For financial advisors, bankers, and policymakers aiming to anticipate and adapt to shifts in risk preferences, understanding what drives variations in risk preferences and how long they may persist is crucial. If changes in risk aversion are minor and short-lived, their impact will also be minimal. However, if the changes are significant and enduring, the effects will be substantial.
Evolving Risk Preferences
Risk preferences are critical for understanding financial decisions. They influence choices involving risk, such as market participation, portfolio selection, insurance demand, and credit choices. Historically, economics considered risk preferences to be constant over time, but it is now recognized that they can change over time and under certain circumstances.
What explains these variations in individuals' risk preferences? Are they mainly due to economic factors or psychological forces? In shock situations like the COVID-19 pandemic, what is the primary factor influencing individuals' risk-taking? More importantly, over what time frame can these variations occur?
Risk preferences can change based on individual-specific variables, such as age, as well as common factors affecting the entire population.
A financial crisis or situations like the COVID-19 pandemic are events that lead to reduced risk tolerance. The traditional approach to explaining changes in risk preferences due to adverse economic events links them to changes in household wealth or future income projections.
One might expect risk preferences to revert to previous levels once wealth is restored and wages stabilize during the economic cycle.
However, it's not so simple. A study by Guiso, Sapienza, and Zingales (2018) shows that the substantial decrease in risk aversion following the 2008 crisis cannot be explained solely by changes in wealth levels. Emotional factors seem to explain the decline in risk-taking.
Risk: An Emotional Experience
Risk and emotions are deeply intertwined. In our brain, risk is encoded as a visceral and emotional experience, and emotions, in turn, affect risk acceptance.
For example, mood can be temporarily affected by weather conditions, and changes in light exposure can alter risk aversion and, consequently, influence financial decisions (Kramer & Weber, 2012).
Terrifying news and distressing tweets about the death of thousands of people in a day, interactions with friends who have lost jobs or money in the markets—these all trigger emotional responses. It's easy to imagine that catastrophic events, whether economic or otherwise, can provoke strong emotional reactions such as fear, leading to increased risk aversion. This explains why even investors who do not lose money become more reluctant to take risks during market declines.
While these emotional reactions are natural and likely to have temporary effects on risk aversion, if the experience is traumatic, emotions can have long-term consequences. Significant and unusual shocks, such as job loss or exposure to a financial crisis, can cause such trauma.
A Lifelong Trauma for Risk Aversion?
Events like the COVID-19 pandemic can thus have a lasting effect on individuals' beliefs and risk-taking, particularly for certain age groups. A study on Norwegian households shows that investors exposed to greater macroeconomic uncertainty at ages 18-23 invest a smaller share in stocks throughout their lives (Fagereng, Gottlieb, & Guiso, 2017). Even those who have experienced low stock returns throughout their lives are less likely to participate in the stock market and, if they do, invest a smaller fraction of their liquid wealth in stocks (Malmendier & Nagel, 2011).
The emotional aspect of this pandemic is strong. It will increase short-term risk aversion, leading to more investment in safe assets like gold and less in risky assets like stocks.
If this incident becomes a traumatic experience for many, it could induce a significant and lasting decrease in risk aversion.
Therefore, it is more important than ever for investment advisors to understand the emotional dimension of risk tolerance. This is likely a key factor in succeeding post-crisis: advisors must personalize their approach to help each client manage their emotions and investments over the long term. Beyond the emotional aspect, the recent market decline presents excellent investment opportunities.
References
Fagereng, Andreas, Charles Gottlieb, and Luigi Guiso. 2017. “Asset Market Participation and Portfolio Choice over the Life-Cycle.” The Journal of Finance 72 (2): 705–50.
Guiso, Luigi, Paola Sapienza, and Luigi Zingales. 2018. “Time Varying Risk Aversion.” Journal of Financial Economics 128 (3): 403–21.
Kramer, Lisa A, and J Mark Weber. 2012. “This Is Your Portfolio on Winter: Seasonal Affective Disorder and Risk Aversion in Financial Decision Making.” Social Psychological and Personality Science 3 (2): 13–99.
Malmendier, Ulrike, and Stefan Nagel. 2011. “Depression Babies: Do Macroeconomic Experiences Affect Risk Taking?” The Quarterly Journal of Economics 126 (1): 373–416.
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