How Our Natural Reaction to the Coronavirus Can Cloud Investing Judgment

Editor’s note: Read the latest on how the coronavirus is rattling the markets and what investors can do to navigate it.

What's our first line of defense when battling germs? Is it our immune systems? Well, there's something even before that. Psychologists have theorized that our initial defensive line against disease is our behavior. This behavioral immune system is a set of psychological tendencies that motivate people to avoid situations that may make them sick.

You can think of the behavioral immune system as a smoke detector for your kitchen. If it catches signs of danger, it sounds the alarm for you to leave the area. We don’t have to be around a person who is sick to activate our behavioral immune system: Just thinking about being sick or seeing pictures of sick people is enough to elicit a response. When you sense danger, that motivates you to seek safety from the threat of illness. That’s useful in daily life, but it can also cloud our financial decision-making.

Like us, the stock market is susceptible to disease. Researchers have seen that a flu outbreak in New York City can decrease the number of trades and the growth rate by 2%-4.6%. Disease can disrupt the market more than other disasters like earthquakes and wars. These results suggest that there's something unique to diseases when it comes to market volatility, and the behavioral immune system may be the reason why.

Just like a smoke detector, this system can sound the alarm when there isn’t actually a problem. That’s not necessarily a bad thing--it’s better to err on the side of caution. Still, these false alarms can lead us in the wrong direction when making investment decisions.

How we can think about our behavioral immune system:

Expect to feel unsettled. The emotions we feel are more than that of a market crash. The threat of disease upsets us in a different way than does an economic threat. We can acknowledge and recognize those emotions. We're not foolish for feeling them, so understanding where they come from can hopefully help us manage them.

Watch out for herd behavior. When we're thinking about germs, we become especially susceptible to social conformity. In everyday life, this can be beneficial: Collective action is a powerful tool to stop the spread of disease. But unfortunately for investing, we are also susceptible to "crowd psychology" when the risk of disease is high. As we're reminded by recent headlines, the crowd isn't feeling optimistic. Investors are understandably worried about the state of the market. This is especially concerning because negative news stories about investor sentiment appear to drive further losses on the stock market.

This isn't to say we should dismiss the recommended precautiouns about the coronavirus. Rather, our behavioral immune system may lead us to err on the side of caution by believing that what other investors are doing must be the right course of action for us. As others at Morningstar have written, we can and should review our individual goals regardless of what others are doing.

Review your financial goals and try to look beyond your current feelings about risk. As a defensive strategy, the behavioral immune system leads us to hesitate taking risks. This means that investors may be collectively tempted to "cut losses" and quickly retreat from the market volatility because of the fear that the market will continue to decline, even if this isn't the right decision. The collective attitudes of investors play an important role in the market's performance. The market downturn we're seeing now is likely a reflection of those attitudes, and not necessarily attributable to performance itself.

Beware of judgments based on appearance. Imagine that you are sitting next to someone who has a runny nose and sneezes often. Chances are, you'll find a new seat, but not because you dislike your neighbor--you are simply avoiding becoming sick. Unfortunately, our behavioral immune system can sometimes take social distancing too far by increasing prejudice against those who are perceived as being contagious, even if they aren't sick. In investing and in life, our behavioral immune system can mislead us into making cursory judgments.