Covariation bias is the tendency for people to overestimate the relationship between fearful stimuli and negative outcomes. The classic example in scientific studies is people’s reactions to spiders. Death from spider bites are extremely rare and there hasn’t been a recorded spider death in Australia (where spiders are most common) since 1979 (see here and here). But you’d be hard pressed to find someone who doesn’t think that spiders are pretty scary animals.
In the financial markets we constantly overestimate the impact of negative events. Like our perception of spiders, we have a tendency to overestimate the occurrence of negative events. But scary stories always make for great story telling.
I suspect this is one reason why many market participants (and certainly the media) are attracted to permabears. After all, we seem to see the same line-up of scary storytellers on CNBC and Bloomberg week after week. There’s often a perception that these permabears are “smarter”, but I have to wonder if they are smarter or merely great storytellers. I mean, it’s pretty easy to paint a bullish story about the future, but it takes a much more intricate and fanciful story to go against the grain and argue that markets will do something that they generally don’t do (go down for sustained periods of time).
The permabear captures our most sensitive emotions and reels us in one bias at a time. This is even more interesting in the context of the many studies on spider perceptions in children.³ Children don’t know the first thing about spiders, but are bombarded with scary stories (told by great storytellers) about how a spider is potentially life threatening or harmful. This creates the completely irrational perception that spiders are extremely dangerous.
Many market pundits and media commentators use the same types of techniques to capture our irrational fears about things we don’t really understand that well (money and markets). And by playing on these emotions they create the perception that they know more than they really do. Unfortunately, great storytelling isn’t always correlated with great intelligence, but that doesn’t stop us from hanging on their every word time and time again….
1 – Burke Museum – Myth: Deadly Australian/Brazilian spiders
2- Anthropod Ecology – Spiders Do Not Bite
3 – NCBI – Spider fear and covariation bias in children and adolescents
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.