THE PELTZMAN EFFECT AND MARKETS.

The Peltzman effect and markets.

Back in the 70s is when they introduced seat belts in cars. This was believed to reduce accidents and hence hailed as a major progress in automobile industry. However, what happened was quite the opposite! Instead of road accident deaths coming down they actually went up!

Similarly, thru constant improvement in the equipment, the process etc, the probabilities of accidents in skydiving has been reduced to a small number. And these have been coming down year after year as everyone works to make the process safer. However, the actual number of accidents has actually gone up!

This puzzling phenomenon has been explained by an economist, Sam Peltzman, who said that as perceptions of risk decrease, people take more risks! It is almost as though we all have, within us, a certain risk threshold that needs to be met and as the external environment deals with risk and tries to diffuse it, people do things that takes the risk level to or beyond the threshold level! As a result, they end up achieving the very opposite of that what they desired! Today this explanation bears his name and is known as the Peltzman effect..

The additional safety that a seat belt provides makes many drivers more reckless (driving faster, not paying as much attention, etc.) under the comfort of the added safety. The added safety features in skydiving makes people careless about not pulling the cord on time or whatever else it is that they do when they dive (I have no idea as I have, regretfully, never done skydiving!) and ending up taking more risks during the dive, leading to increased accidents!

We see evidence of the Peltzman effect in the markets too. Traders who set stops tend to take bigger risks with their positions. Investors who are given a story about a stock stay in it well beyond their capabilities to handle the drawdowns just because they overestimate the validity of the story. By setting a stop or being given a convincing story, you have not addressed the risk.  But you think you have and that makes you either over confident or sometimes even reckless and that can create big problems in the market.

The markets trend also creates its own version of the Peltzman effect. A sustained rise or fall that lasts multiple weeks creates a lowered impression of risk of trading in that direction. So people tend to get into stock moves late in the game believing that the risk is low because they are now “going with the trend”. They then get surprised when the trend (which is overextended) turns and smacks them in the face!

This behaviour also reflects in the tendency to seek out proxy plays to large caps that move aggressively. Suddenly people start finding virtues in small cap names that are in a vaguely similar business and begin to think of those as “low risk” buys as they expect it to mimic the moves of a large cap leader stock. Sometimes this linkage goes to ridiculous extents where people are ready to buy into stocks that have similar sounding names!

What is common here? The perception of risk and the subsequent action that it produces. When people believe that the risks are lower or addressed in some way, they tend to take greater risks in what they are doing. Nefarious operators these days are taking advantage of this very behaviour pattern of small investors by sending SMS messages cleverly disguised as though they are coming from large broking houses. Mistaking the names to be big names (and therefore unlikely to be risky, if their research has produced these calls), many small investors buy into these names and get trapped.

The world over, volatility levels have seen a drop in almost every market and every asset class. Equity markets are performing big time in almost all the regions of the world. Many of the current active players are post 2010 entrants. They have also been influenced in the last year or more by dazzling moves of crypto currencies and major indices and stocks. Tech leaders like Apple and Amazon have created an image of solidity to which has got added the excitement of the likes of Facebook and Twitter. Similarly in Indian markets, there are scores of stocks that have become multi-baggers in a short period of time.

Not having experienced major market declines in the last many years and lulled into a sense of complacency created by the big names and the success that some long term investors have created, many of the current crops of investors and traders are more than likely to believe that the stock markets currently carry “very low risk”. In line with that perception and the Peltzman effect, the most likely thing they are likely to do now is to take on higher risk.

No wonder some major market pundits are calling for a melt up rather than a melt down!