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
new 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 who teaches the first-year
MBA course on financial markets. 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

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

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” has not yet been submitted for publication, but
Nagel and Malmendier are already working on a follow-up project. 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 percent 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

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