By Nicholas Colas of DataTrek Research
“Fear of missing out” may be the most misunderstood phrase of 2021. It does not explain hasty decision making. Its origins are in consumer marketing and it is meant to throw light on why people forestall decision making or regret the decisions they do make. What passes for FOMO now is better explained through Prospect Theory. Novice retail investors are willing to part with generally small sums of money in return for the hope of large gains. They have enough FOMO in other parts of their lives (social media sees to that). Investing is one escape from that.
We’ve been thinking about retail investors this week. This led us to the concept of “fear of missing out”, or FOMO. It seems to crop up quite often when discussing this new investor cohort. They buy stocks not for any rational reason, but rather because they see it mentioned in social media and do not want to miss out on gains others might enjoy if the idea works. Or so the idea goes …
“Fear of missing out”, as we’ll discuss today, is a useful twist on an important behavioral finance topic and has lessons beyond investing. But we’re getting ahead of ourselves …
Three points on “Fear of missing out”:
#1: As a term, its origins are in marketing. The phrase “fear of missing out” was coined by Dan Herman, a marketing consultant, in 1996 based on his observations from consumer focus groups. From his website:
“Despite a variety of research topics and business categories being explored, most consumers expressed – at one time or another – a clearly fearful attitude towards the possibility of failing to exhaust their opportunities (and complimentarily, to miss the expected joy associated with succeeding in doing so).”
“Missing out is inevitable. The Fear of Missing Out, on the other hand, is an emotional reaction resulting from the attitude of holding having options open to us in high regard.”
“My research shows that approximately 70 pct of all adults in developed countries experience FOMO to varying degrees. The ability to cope well with FOMO correlates positively and significantly with financial success, social success and high levels of life satisfaction.”
Takeaway: the greater the number of potential choices, the greater the chance that FOMO will play a role in either making or not making a decision. No surprise, therefore, that we increasingly hear about “fear of missing out” in an ever more connected world where we can see a virtually limitless array of options. On top of that, social media allows us to see other people’s choices, and this also feeds into our fear that the best party is always the one we’re not attending.
#2: FOMO is a variation on Prospect Theory. Back in 2002 Daniel Kahneman won the first Nobel prize awarded for a construct from behavioral rather than classical economics. His “big idea” was that humans don’t value future outcomes in a linear fashion. For example, the prospect of losing $100 is roughly twice as distressing as the prospect of winning $200 is pleasant. A simple example of how this works:
Say someone offered you a choice of $1,000 or a coin-toss bet for $2,500. Call the toss correctly, you win $2,500. Get it wrong and you walk away with nothing.
This should be an easy decision: the expected value of the $2,500 coin toss is $1,250. That’s more than the $1,000 sure thing, so you should go for the riskier option.
In countless experiments around the world, however, many people choose the sure thing even though the expected return of the coin toss is greater. The prospect of walking away with nothing is too much to bear (hence why this is called Prospect Theory) because it feels like a loss.
Takeaway: While Dan Herman’s FOMO construct centers on a large number of choices as the enabler of “fear”, Prospect Theory gets to the core of the issue. Anticipated regret is a powerful force in human decision making.
#3: FOMO is therefore a reason for inaction (too many choices) or regretting the options you choose (another one might have been better), not really an explanation for why someone moves quickly and indiscriminately. So, what’s happened to make FOMO a call to action for the new cohort of retail investors? A few thoughts:
New retail trading apps have lowered the cost of trading to effectively zero, have almost no account size minimums, and allow trading of as little as one share.
Newer investors tend to be younger and more active on social media. Research shows this correlates strongly with the worst emotional aspects of “fear of missing out”, so this cohort is primed to take action rather than feel left out.
In many cases, their account balances are small (about $4,500 at Robinhood, on average). Some were even funded by last year’s fiscal stimulus checks, so they are essentially “house money”.
This new group of investors therefore see the game differently from prior generations. There are zero friction costs to throw a few hundred dollars at a name they hear about on social media. If it works, great – FOMO avoided. If it doesn’t, the losses are usually manageable.
Compare this to, say, 401(k) investing (the defined contribution plans popular in the US). For years, plan participation was low in part because the typical program had +30 investment options. This created legitimate FOMO (what if I choose the wrong thing?) which was compounded by the pressure of knowing you were trying to amass enough capital to retire comfortably one day. The new form of retail trading looks nothing like that, so we shouldn’t expect retail traders to act the same way.
Takeaway: going back to our example in Point #2, retail traders think the coin toss is for $5,000 and the sure thing offers $1,000. That is enough to tip the scales in favor taking the risk because it clears the hurdle Prospect Theory poses. FOMO only drives action when the potential losses are small and gains theoretically large. Does all this pose any systematic risk to equity markets? The short answer is we don’t think so, at least not as long as account balances are small. When the average Robinhood trader has $50,000 or is using a HELOC to fund their account, we will start to worry. But probably not before.
Dan Herman website: http://www.danherman.com/The-Fear-of-Missing-Out-(FOMO)-by-Dan-Herman
Prospect Theory original paper: http://www.albacharia.ma/xmlui/bitstream/handle/123456789/31987/kahnmtversky.pdf?sequence=1