Author: Dr. Alexandra Dobra-Kiel
Dr Alexandra Dobra-Kiel, who leads the CFA UK Ethics Book Club run by the CFA UK’s Ethics Committee, writes for Professional Investors about how Covid-19 is increasing ethical risk
Covid-19, which has triggered a financial anxiety pandemic, offers an excellent context to demonstrate how insights from the CFA UK Ethics Book Club can be applied. That is, Covid-19 helps illustrate how behavioural science can safeguard fund managers against both underperformance and ethical risk.
This article unpacks the ethical risk behind the Covid-19 financial anxiety pandemic. In doing so, it addresses the question of how emotional contagion can fuel ethical risk. It then sets out a few behavioural science tools that fund managers can use to counter the impact of emotional contagion.How is ethical risk fuelled?
When Covid-19 became a health pandemic rather than a health epidemic, the volatility of the financial market soared. The VIX index (also called the ‘fear index’) was higher on March 13, 2020 than when Lehman Brothers collapsed on September 15, 2008. In other words, to paraphrase Robert Shiller, Covid-19 had triggered a pandemic of financial anxiety.
Following aggressive monetary stimulus from central banks, the main stock market indices have recovered part of their losses. However, investors appear to be positioning themselves for a further decline. Indeed, there is no (historical) evidence that financial markets can rise steadily as economic indicators continue to show a collapse. Hence, the spectre of a pandemic of financial anxiety has not withered away.
Financial anxiety pandemics are fuelled by emotional contagion that affects the way investors process information and make decisions.
Emotional contagion is a three-step process by which the emotions of one investor are transferred to another investor. This can happen through face-to-face interactions, as well as virtual interactions (for example, media and social media).
Two factors influence the degree of emotional contagion, namely the valence (positive or negative) of the emotion and the intensity of the emotion. In the context of the Covid-19 financial anxiety pandemic, the valence is (strongly) negative and the level of intensity is (very) high. This leaves the door wide open for negative emotional contagion to occur.
This emotional contagion, in turn can fuel ethical risk. Indeed, negative emotions tend to narrow the range of an individual’s thoughts and actions. In addition, time pressure can also contribute to narrow these further, as the individual begins to display anxiety, impatience and despair. Subsequently, the emphasis on task completion increases further.
Therefore, negative emotions can increase ethical risk, as less attention for anything but the task at hand (i.e., generating performance) is provided. Furthermore, especially under conditions of time pressure anger is likely to be triggered (i.e., perceived tensions between ethical requirements and performing the task) and will tend to narrow the individual’s actions to confrontation and attack. These actions of confrontation and attack can result in ethical violations.
Given the impact of emotional contagion on ethical risk, it is important to counter its impact.
How to counter ethical risk?
To effectively counter emotional contagion, investors can apply two approaches: de-biasing and nudging.
The purpose of de-biasing is to ‘modify the investor’ to help them make better decisions. De-biasing can be implemented by providing the investor with a combination of knowledge and tools to help them overcome their limitations and predispositions. In order to reduce emotional contagion, the most effective techniques of de-biasing are:
- Consider alternatives (i.e. allow the investor to identify alternatives to their decision)
- Mental rehearsal (i.e. allow the investor to become aware of the biases involved in their decision)
- Reduce difficulty and ambiguity (i.e. help the investor break down their decision(s) sequentially)
Nudging, on the other hand, aims to modify the framework in which decisions are made, in order to encourage the investor to change their decisions but without forcing them to do so. This approach accepts the existence of behavioural biases, but allows situations to be created in which these biases are irrelevant. Nudging can be implemented through changes in the interface of the investment software. In order to reduce emotional contagion, the most effective nudging techniques are:
- Induce a forward-looking reflection (i.e. encourage the investor to return to the basics by projecting the return on their assets over the medium/long term. Thus, the interface of the investment software can open on a screen projecting return scenarios on the medium/long term of the investment).
- Default options (i.e. activate the investor’s inertia to reduce the temptation to sell/buy quickly. Thus, the interface of the investment software can render the act of sale/purchase laborious).
If you want to learn more about applying behavioural science to safeguard both performance and ethical standards, we are looking forward to welcoming you at the next event of the CFA UK Ethics Book Club.
Dr Alexandra Dobra-Kiel is Banking & Capital Markets Insight Lead at one of the Big Four and Guest Lecturer at Warwick Business School. Dr Dobra-Kiel applies behavioural science to promote the highest levels of ethical conduct among fund managers.
This article is written on behalf of the CFA UK Ethics Committee. The ‘Ethics Book Club’ was launched in July 2019.