STANFORD GRADUATE SCHOOL OF BUSINESS—Your grandmother’s habit of hoarding pennies in a jar notwithstanding, until now there’s been no hard evidence that economic events like the Great Depression actually change investment behavior. A study by Stefan Nagel and Ulrike Malmendier, however, stands conventional economic wisdom on its head. They have successfully demonstrated that personal experience does matter – and that the economic times we live through have a significant impact on how we invest our money.
“Economists have traditionally not made a distinction between knowledge and experience,” said Nagel, an associate professor of finance at the Graduate School of Business. His coauthor is associate professor of economics at the University of California, Berkeley. Both Nagel and Malmendier were born in Germany and had been similarly struck by the fact that older relatives who had lived through a period of hyper-inflation in the 1920s seemed to have different attitudes toward investing than later generations.
“Conventional economic models assume that data is data—and that it doesn’t matter if you actually lived through the Great Depression or just read about it,” said Nagel. “But we found that experiences have significant effects—even decades after the fact.”
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.
What they found was instructive. Individuals who had experienced high stock-market returns throughout their lives were less risk adverse, were more likely to participate in the stock market, and more inclined to invest a higher percentage of their wealth in stock. Alternatively, those who experienced high inflation were less likely to invest assets in bonds, preferring inflation-proof cash-like investments.
Perhaps not surprisingly, 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. Thus the low returns in the 1970s made younger investors more risk averse through the 1980s. 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 and were therefore more confident that the market would rebound.
As to whether the severity of a downturn—or the extra-high returns of a prosperous period—had a more lasting impact on investors than a milder economic event, Nagel and Malmendier were not able to verify. “It’s plausible, but the data didn’t allow us to measure that with enough precision,” said Nagel.
The implications of this study—especially for how things might play out in the next few years—are notable. Precisely because difficult economic times make investors less willing to take risk, bad experiences can lead to a vicious circle. Investors, skittish because of recent —and in many cases massive—losses, can be loathe to put money back into markets even after they stabilize. “This can amplify recessionary effects, and prolong economic downturns,” said Nagel.
The research paper, “Depression Babies: Do Macroeconomic Experiences Affect Risk-Taking” was published in the Quarterly Journal of Economics, February, 2011. Their next goal: to determine how much of this “experience affect” on investing can be attributed to changes to individuals’ risk preferences, and how much to changed beliefs. The difference is subtle, but important. A belief is a person’s expectation of what is likely to transpire: is the market likely to do well over the next 10 years (an optimistic belief) or poorly (a pessimistic belief)? A risk preference, on the other hand, determines what a person is likely to do based upon that belief.
“For example, if you believe that the stock market is going to provide 10% returns over the next 10 years, you’ve got optimistic beliefs,” said Nagel. “But whether you are willing to invest in the market during that time period based on your belief has to do with how risk-averse you are.” By examining the difference between risk preferences and beliefs, Nagel and Malmendier hope to more finely delineate the impact of major economic events on future investment behavior.
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