Crash Beliefs from Investor Surveys

Dasol Kim is Assistant Professor of Banking and Finance at Case Western Reserve University Weatherhead School of Management. This post is based on a recent paper authored by Professor Kim; William Goetzmann, Edwin J. Beinecke Professor of Finance and Management Studies, and Director of the International Center for Finance at Yale School of Management; and Robert J. Shiller, Sterling Professor of Economics at Yale University.

Investors’ beliefs about whether a severe market crash is impending can affect the prices and expected returns on risky assets, such as publicly traded stocks. However, beliefs regarding extreme market events are difficult to measure using typical economic data, precisely because they are low-probability outcomes. Observed asset prices are also determined by investor preferences, such as their degree of risk tolerance, as well as by beliefs about future outcomes. Probabilities about extreme events are usually inferred from asset prices, and disentangling probabilities from risk preferences presents problems.

In our paper, we turn to a different source of information about rare crash probabilities. Since 1989, Robert Shiller has been surveying individual and institutional investors. One question in the survey asks respondents to estimate the probability that a severe crash will occur over the next six months. The definition of a crash is specific: a drop in the U.S. stock market on the scale of October 19th, 1987 [-22.61%] or October 28th 1929 [-12.82%].

We use the Shiller survey data to examine the magnitude of crash probabilities reported by individual and institutional investors. We find evidence that the average, subjective probability of an extreme, one-day crash on the scale of 1987 or 1929 [i.e. greater than 12.82%] to be an order of magnitude larger than would be implied by the historical frequency of such events in the U.S. market. Over the 1989 to 2015 period, the mean and median probability assessments of a one-day crash were 19% and 10%, respectively. In comparison, historical data from 1929 to 1988 indicate that the likelihood of such a crash is only 1.7%. To the extent that this rare crash risk is priced, our analysis suggests that it may function through extreme probability assessments rather than through risk aversion.

We find that crash probabilities vary significantly through time and are correlated to measures of jump risk such as the VIX and the occurrence of extreme negative returns. Motivated by these observations, we investigate behavioral channels that could contribute to this phenomenon by examining whether investor crash beliefs are subject to media influence. We start by showing that stock market downturns are more likely to be reported in financial media than upswings. The valence of news items that are likely to draw greater attention are also more sensitive to recent stock market performance than other news items.

We posit that investors may exhibit “availability bias” in forming their crash beliefs. The availability heuristic (cf. Tversky and Kahneman, (1973)) is the tendency to use easily recalled events to estimate the probability of an event occurring. Individuals prone to the availability heuristic “bias” their probability beliefs by giving more weight to “top-of-mind” data. Tversky and Kahneman (1973) tests show that it is possible to induce this bias through priming or framing. The contribution of our study to research on the availability heuristic in finance is that we directly test its relationship to probability estimates; the setting in which the hypothesis was originally formulated by Tversky and Kahneman (1973). The availability heuristic is particularly pertinent to investment decision-making because probability assessment of events—for example, the likelihood of tail risk events—affects investor allocations to risky assets. If investors give too much weight to recent market events—perhaps because they look at recent investment outcomes—this may cause them to incorrectly estimate the probability of a crash. By the same token, the media may frame recent events through selective reporting—emphasizing negative outcomes and thus making them more available when a subject is asked to assess the probabilities of a related event.

We test for the incremental effects of valence of articles about the market on the days prior to the survey. We find evidence that the financial press mediates investor crash beliefs, and does so asymmetrically. Articles with negative valence are associated with higher crash probability assessments following market downturns, but articles with positive valence have no effect. We explore the question of whether this association operates through the availability heuristic, and extent to which affect plays a role.

We find evidence that investors use recent market performance to estimate probabilities about a crash. We show that the press makes negative market returns relatively more salient and this is associated with individual investor probability assessments of a crash. This latter mechanism is consistent with Barber and Odean (2008), Engelberg and Parsons (2011), Kräussl and Mirgorodskaya (2014), Yuan (2015) and other research documenting evidence that the news plays an important role in focusing investor attention and influencing behavior. Finally, we also find evidence consistent with an availability bias when examining the crash probabilities of investors who recently experienced exogenous rare events; in this case, moderate earthquakes.

Johnson and Tversky (1983) observe that “judgments about risk…seldom occur in an emotionally neutral context.” They find that emotion induced by brief reports about negative events have a major effect on probability assessments. This has come to be termed the affect heuristic (Slovic et. al. (2007)). Paul Slovic and co-authors, as well as other researchers (cf. Keller et. al. (2006)) have explored how emotions—particularly fear and dread—influence probabilities assessment. It is interesting from a finance perspective that their research identifies an inverse relationship between expectations of risk and reward—the opposite implied by standard financial models. The affect heuristic is similar to the “risk-as-feelings” model proposed by Lowenstein et. al. (2001), who propose that risk is perceived experientially and is therefore subject to the broad variety of factors known to influence emotions, including vividness of outcomes, personal experience and mood. The affect and availability models are not necessarily mutually exclusive.

The research findings add to a large literature on the ways in which financial decision-making may deviate from textbook models of rational choice. The findings may help to inform other areas where rare disaster concerns are relevant, including the equity premium puzzle, time-varying market premiums, cross-sectional differences in asset returns, the volatility smile, and investor choice.

The full paper is available for download here.


Barber, B.M. and Odean, T., 2008. All that glitters: The effect of attention and news on the buying behavior of individual and institutional investors. Review of Financial Studies, 21(2), pp.785-818.

Engelberg, J. E., & Parsons, C. A. (2011). The causal impact of media in financial markets. The Journal of Finance, 66(1), pp. 67-97.

Johnson, E.J. and Tversky, A., 1983. Affect, generalization, and the perception of risk. Journal of personality and social psychology, 45(1), p.20.

Keller, C., Siegrist, M. and Gutscher, H., 2006. The role of the affect and availability heuristics in risk communication. Risk analysis26(3), pp.631-639.

Kräussl, R. and Mirgorodskaya, E., 2014. News media sentiment and investor behavior (No. 492). Center for Financial Studies (CFS).

Loewenstein, G. F., Weber, E. U., Hsee, C. K., & Welch, N. (2001). Risk as feelings. Psychological bulletin, 127(2), 267.

Slovic, P., Finucane, M.L., Peters, E. and MacGregor, D.G., 2007. The affect heuristic. European journal of operational research177(3), pp.1333-1352.

Tversky, A. and Kahneman, D., 1973. Availability: A heuristic for judging frequency and probability. Cognitive psychology, 5(2), pp.207-232.

Yuan, Y., 2015. Market-wide attention, trading, and stock returns. Journal of Financial Economics, 116(3), pp. 548-564.

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