The science behind why the word ‘recession’ makes people panic

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Mark Chappel

16 Oct 2019

We tend to think of the market as being quite rational. If a stock goes up, it’s because potentially thousands of investors around the world see it as a good company to hold so it could be a good idea for you to hold it too. But here’s the thing. Investors are people and people are definitely not as rational as we might want to believe.

Behavioural bias

I recently picked up the bestselling book Thinking, Fast and Slow by Daniel Kahneman and it’s amazing to think about how much we make snap, intuitive decisions that are often a result of our behavioural biases. These can lead even the most experienced investors into unintended consequences.

One of my favourite examples is the 'anchoring' bias. This is essentially our tendency to use the first piece of information – such as the advertised price of a used car – as our ‘anchor’ for subsequent judgements. For instance, if the car is advertised at £4,500 then a special offer of £3,800 will seem like a good deal, despite the car only being worth £3,000. It can be really difficult to ignore that first piece of information and requires us to know, or research, what the fair value of our purchase should be before making that decision.

Recessions and misleading thoughts

Now think of the word 'recession' and what springs to mind. For me, it conjures huge investment losses and the collapse of banks like Northern Rock and Lehman Brothers. But I've just fallen victim to 'recency bias'. The most recent recession was the 2008 financial crisis so it's immediately what my mind jumps to.But here's why that's my brain being misleading.

 

According to our economists, the next one seems likely to be more in line with the average than the global financial crisisWhy? As it stands, the US economy (the one which has grown for the longest since 2009 and therefore the key economy investors watch most closely) is in a fairly strong position. The banking sector is much more robust than in 2008 – I'd recommend the film The Big Short as a great dramatisation of the position the banks were in – and the Federal Reserve is not afraid to intervene to help keep the economy growing. Plus, as we've discussed before, President Trump has a great opportunity to give markets a boost whenever it seems most helpful for his political situation.

So while the word 'recession' definitely sounds scary now, it shouldn't have to. When memories of 2008 loom so large in our minds, it seems like all recessions from now on are going to be as big and as damaging as that one was. But despite today's political uncertainty, the underlying economy is still in fairly good shape. Maybe a little bit of slower thinking is exactly what all of us investors need.

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