How past experience impacts investing decisions

Most know-your-client forms don’t ask about the macroeconomic conditions during a client’s formative years. They don’t tend to inquire about the client’s taste for horror movies, either. Yet both may have something to say about risk tolerance.

The 2008 financial crisis is widely believed to have influenced millennials’ approach to risk. The same is said about those who lived through the Great Depression. A 2008 paper from researchers at Stanford University and the University of California, Berkeley¹ found that while investors put more weight on recent stock-market returns than on distant performance, “experiences several decades ago still have some impact on current risk-taking of older households.”

A couple of more recent papers have examined how local economic hardship affects risk behaviour. In one, an economics professor from Simon Fraser University² used data from Japan to show that men who experienced local economic shocks between the ages of 18 and 21 saw their risk aversion (as it applies to investments and self-employment) increase by roughly 0.2 standard deviations. The effect lasted into subjects’ thirties and forties. The author found the impact is most acute when the shock is experienced during the “impressionable years” of early adulthood.

The other paper, from a visiting business professor at Georgia Tech³ examining almost a century of U.S. data, found that state-level economic conditions during teenage years, especially, have a substantial impact on risk behaviour. “Individuals who begin their lives by observing an economic downturn remain pessimistic and risk averse with respect to investments over the course of their lifetimes,” the paper says, resulting in decreased stock investments and business ownership, and increased investment in low-interest savings accounts and home equity.

Professors of finance and psychology at the University of Pennsylvania⁴ provide the psychological background. The “retrieved-context theory” says that a present-day stock market loss can remind the investor of a previous loss. “The point is that memory itself produces a distorted database because the agent relives his worst fears when a stock market downturn occurs,” the paper says.

This can happen even when the new fear isn’t related to finance. Academics from the University of Chicago, Northwestern University and the Einaudi Institute for Economics and Finance in Rome⁵ examined 2009 data from an Italian bank and found that the financial crisis made clients more risk averse. While not revelatory on its own, they also found that those who didn’t actually experience financial loss felt the same increased risk aversion: those clients rebalanced their portfolios by selling risky assets, which the authors said is consistent with a fear-based model, showing they were emotionally affected by the crash even if it didn’t affect their bottom lines.

This led the researchers to examine the underlying emotion. They used an experiment with horror movies to show that fear alone, without any new information about the economy or stock market, affects risk behaviour.

A sample of students watched a five-minute torture scene from Eli Roth’s 2005 movie Hostel. Those students exhibited higher risk aversion, very similar to what the bank clients had experienced in 2009: their certainty equivalent — the guaranteed return they would accept now rather than taking a chance on a higher, uncertain future return — was 27% lower than students who hadn’t watched the clip.

“Since the outside environment of the treated and non-treated sample is the same, the experiment is able to show that emotional fear (i.e., fear that is not related to changes in the outside environment), experienced at the time of the decision, causes an increase in risk aversion,” the paper says.

The UPenn authors said the response of students in the horror movie experiment is a good test of their retrieved-context theory. “It is as if the movie reminds the agent that the world is a risky place, and one thus should not take risks with one’s financial wealth,” the paper says. The context should be irrelevant, but it isn’t.

What does this mean for your clients? First of all, it’s worth discussing how the economic climate during the client’s formative years may inform their investment approach.

It may also be useful to find out what a client has been doing the day of a meeting. Were there layoffs at their company? Was a child hospitalized for a concussion? Were they nearly run over by a cement truck crossing the street to your office? Are they arriving directly from a Hostel marathon at the local independent cinema? If watching five minutes of a scary movie impacts risk tolerance, consider all the real-world concerns that could be distracting the person sitting across from you.

Papers discussed

1. Ulrike Malmendier and Stefan Nagel, “Depression Babies: Do Macroeconomic Experiences Affect Risk-Taking?” National Bureau of Economic Research Working Paper No. 14813 (March 2009).

2. Hitoshi Shigeoka, “Long-Term Consequences of Growing up in a Recession on Risk Preferences,” National Bureau of Economic Research Working Paper No. 26352 (October 2019).

3. Erin McGuire, “The Long-Run Influence of Local Economic Conditions on Financial Decision-Making,” SSRN (May 2019).

4. Jessica A. Wachter and Michael Jacob Kahana, “A Retrieved-Context Theory of Finance Decisions,” National Bureau of Economic Research Working Paper No. 26200 (August 2019).

5. Luigi Guiso, Paola Sapienza and Luigi Zingales, “Time-Varying Risk Aversion,” National Bureau of Economic Research Working Paper No. 19284 (August 2013).