Economic Experiences Influence Investment Behavior

A recent paper suggests the economic times people live through have a significant impact on how they invest.

In their study, Stefan Nagel, Associate Professor of Finance, Stanford Graduate School of Business, and Ulrike Malmendier, from the University of California, Berkeley, found individuals who had experienced high stock market returns throughout their lives were less risk adverse, more likely to participate in the stock market, and more inclined to invest a higher percentage of their wealth in stock. In contrast, the researchers found those who experienced high inflation throughout their lives were less likely to invest assets in bonds, preferring inflation-proof cash-like investments, according to the Stanford Graduate School of Business News.

The study indicated that the more recent an economic experience, the more impact it had on investor behavior overall, and young people tended to be more affected by recent events than older people. “Because they have a limited history, they are much more likely to change their behavior due to a single year’s performance in the markets than an older person, who might have several decades of experience,” said Nagel, in the news report.

For example, the low returns in the 1970s made younger investors more risk averse through the 1980s, as they pulled their money out of the stock market at higher rates than older investors, who still had memories of better returns in the 1950s and 1960s giving them confidence that the market would rebound.

The news report noted that the implications of this study for how things might play out in the next few years are notable. Because of recent — and in some cases massive — losses, investors may be loathe to put money back into markets even after they stabilize. “This can amplify recessionary effects, and prolong economic downturns,” said Nagel, in the news report.

Nagel and Malmendier were not able to verify whether the severity of a downturn or overly high returns of a prosperous period had a more lasting impact on investors than a milder economic event.

To test their hypothesis, Nagel and Malmendier took 40 years of cross-section data on household asset allocation from the Survey of Consumer Finances, and extracted portfolio allocations, risk aversion metrics, and stock-market participation. They controlled the model to eliminate differences due to demographics, wealth, income, and other variables.

The research paper, “Depression Babies: Do Macroeconomic Experiences Affect Risk-Taking,” is located here.