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6.4 Contagion

This is an image of a row of matches.
Figure 10 Financial contagion can spread like wildfire,

So far we have discussed the influence of individual behavioural biases and their potential influence on decision-making, but arguably group decision-making biases are more influential and powerful. There is substantial evidence of the behaviour of entire organisations being influenced by the environment within which they operate.

Contagion is the first of these group decision-making biases we will examine.

Contagion refers to situations that often arise in financial markets where a price movement that arises for one asset quickly spreads to other assets that are similar but not the same. Contagion can have positive and negative connotations – i.e. prices can be quickly driven up or down. Consequently, the impact is not always negative for investors.

A good example is the Asian currency crisis that unfolded in 1997. This was triggered by the collapse of the Thai Baht. Thailand had heavy domestic and foreign debt and a currency that was pegged to the US Dollar. Debt grew, investors lost confidence and the Thai Baht underwent a heavy devaluation as foreign investment moved out of Thailand. Investors quickly looked at other countries that had a similar economic profiles as Thailand, including Malaysia and Indonesia, and developed the same adverse sentiment about these economies. These countries quickly followed Thailand with devaluations of their own currencies.

A key symptom of contagion is that decision makers will increasingly be satisfied with ‘a best fit’ comparison between assets. Conditions do not need to match perfectly but merely be similar to trigger action.

We can probably all think of an example of an event where contagion has applied. In 2011, the government budget deficits of members of the European single currency (Euro) were under great scrutiny. The debt crisis that started in Greece and Ireland had spread to Portugal, with all three economies requiring international financial rescue packages to be arranged. Spain and Italy then came under examination and found that the contagion of fear amongst investors had spread to their debt markets.

Contagion can take hold very quickly and can present a difficult challenge for investment managers. Ensuring that the analysis surrounding decisions is kept objective, considered and of a consistent quality is key to avoiding making decisions that become driven by contagion.