The Contagion Effect: How Fear Travels Faster Than Facts in Markets

Markets move on information, but they often move even faster on emotion. A single piece of bad news can ripple across stocks, sectors, or even countries before anyone has confirmed all the details. This dynamic is known as the contagion effect—when fear or stress in one area spreads rapidly to others. When it comes to finance, the contagion effect means that perceptions can sometimes outrun facts.

Table of contents

• Why panic spreads so quickly
• The role of behavioural finance
• When fundamentals and psychology overlap
• Guardrails that could help
• The bigger picture

Why panic spreads so quickly

Fear has served a vital evolutionary purpose: reacting quickly to danger was essential for early humans. But in the modern day, this may at times be counterproductive. In markets, this instinct might push investors to act before they have complete clarity. That urgency may feel sensible in the moment, but it can also exaggerate sell-offs.

When one group of investors sells, others might assume that group knows something important. This is a form of herding, where people follow the crowd rather than relying on their own information. In uncertain conditions, this herding may snowball, turning small drops into broader declines. Social media and round-the-clock news can accelerate this further, making rumours appear like established facts.

Read Also: Behavioral Finance: Meaning, Types, and Its Importance

The role of behavioural finance

This is where behavioural finance comes in. Behavioural finance is the study of how psychological tendencies and social factors can influence financial decisions. Unlike classical models that assume investors are fully rational, behavioural finance highlights biases and shortcuts that could cause people to overreact, underreact, or misinterpret information.

The contagion effect is one area where multiple behavioural biases intersect. Research has identified patterns like:

• Loss aversion: The pain of losing tends to feel stronger than the joy of gaining. This might push investors to cut risk faster than the data warrants.
• Availability bias: Recent, vivid events may feel more likely, making dramatic headlines outweigh quieter evidence.
• Confirmation bias: Once a negative story takes hold, investors may look for information that reinforces it, while ignoring data that contradicts it.
• Ambiguity aversion: When facts are unclear, people may prefer to exit positions “just in case,” widening the market reaction.

Together, these biases show how psychology could magnify financial contagion.

When fundamentals and psychology overlap

It’s worth noting that contagion isn’t only about psychology. Markets are linked through real financial channels: banks lend across borders, investors hold baskets of securities, and companies share supply chains. A shock in one area may affect another. What behavioural factors add is speed and scale—the possibility that the reaction could be sharper than fundamentals alone might explain.

For example, a regulatory rumour about one company could trigger selling in its peers, then in the broader sector, and eventually even in unrelated areas if investors rush to free up cash. Later, facts might show the initial rumour was less severe, but by then the contagion effect may already have caused significant swings.

Example for illustrative purposes only.

Read Also: Impact of Behavioural Finance on Market Conditions

Guardrails that could help

Because biases are part of human nature, it may not be possible to eliminate them – and the interplay of emotions and finances isn’t inherently a negative thing. But recognising them may help investors avoid being swept up by fear. Some possible approaches could include:

• Using checklists: Asking structured questions like “What is confirmed?” or “What evidence would change my view?” may reduce knee-jerk reactions.
• Pre-commitment strategies: Deciding in advance how to act under stress (such as setting stop-losses or rebalancing rules) could help counter herding.
• Focusing on base rates: Looking at long-term data might balance the emotional weight of a recent headline.
• Allowing a pause: Even a short “cooling-off” step before acting might prevent impulsive trades.
• Diversification: While it doesn’t remove risk, diversification across sectors or geographies may soften the impact of contagion.

The bigger picture

The contagion effect reminds us that markets are not only about numbers and balance sheets—they are also about people, stories, and the way emotions travel. Facts do matter, but fear may spread faster. By being aware of behavioural finance insights and planning ahead, investors might be better placed to respond thoughtfully rather than react reflexively.

While there are no guarantees, understanding how our own psychology interacts with the market may help in navigating turbulent times.

At Bajaj Finserv AMC, we recognise that emotions are the cornerstone of investor behaviour – not just for investors but for investment professionals too. That’s why, behavioural finance is at the heart of our investment philosophy, InQuBe, which combines the Information Edge, Quantitative Edge and Behavioural Edge. By understanding, tracking and monitoring market sentiments and our own investment biases, we seek to make mindful and strategic investment decisions. Get the Behavioural edge by investing with Bajaj Finserv AMC. Read more about InQuBe here.

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