The ongoing global malaise is a reminder that problems in one market – US sub-prime mortgages – can quickly spread to others – European sovereign debt.
While many now recognise contagion as a financial concept, investors who do not understand what it is and why it happens face the risk of seeing their wealth eroded in the case of an outbreak.
Correlations and contagion
Individual investments whose prices rise and fall with each other are described as being correlated. For example, shares in one company may tend to rise and fall in line with those of another company in a similar industry.
Further, whole groups of investments, such as the share market in general, may tend to rise and fall at the same time as another group of investments, such as property. Groups of investments such as shares and property are known as asset classes.
Investors usually try to limit their risk of losing money by spreading it around both different investments and different asset classes. This is known as diversification and works best when the investments and assets are not highly correlated.
When financial contagion occurs, correlations between individual investments and even different asset classes rise and the usual approaches to diversification may not protect investors against losses. ING group economist Mark Cliffe explains that this was a major feature of the global financial crisis of 2007 and 2008.
Herding does not provide immunity from contagion
Contagion occurs partly due to a tendency of investors to adopt similar patterns of behaviour.
Investors may buy an investment simply because its price has risen or because others have been buying. By following others, which is known as herd behaviour, they may feel they have made a safe investment simply because others have been doing the same thing.
Similarly investors may sell simply because prices have been falling.
When the prices of several investments fall at the same time, investors may be tempted to sell other investments as well. They may do this even though the prices of these other investments have not previously been correlated with those that were falling in the first place.
These extra sales may be driven by a need to raise money to pay for losses incurred on the first investments or simply because investors start to fear losing money. The movement of the herd becomes a stampede and price falls can be widespread, affecting and crossing betwwen whole asset classes. The fall in the price of any one investment can be difficult to explain.
This urge to buy or sell has always been a feature of financial markets and was dubbed animal spirits by the economist John Maynard Keynes.
Investors increase the risk of being affected by contagion if they overestimate their skills and think that rises in the value of their investments are down to their personal choices.
Behavioural economists call this the illusion of control. The illusion of control is not confined to individual investors. Research has found traders who fall victim to the illusion produce lower returns.
Investors who believe that rises in the price of their shares, home or other investments are down to them – rather than a general boom – may take on more risk than they are aware of and leave themselves open to being adversely affected by financial contagion.
As with medical contagion, investors can take steps to minimise the impact on their wealth from the financial version.
Being aware of, being comfortable with and adjusting the amount of risk in a portfolio of investments is a good start.
But remember that contagion can be indiscriminate and even those best prepared may still face losses.