John Keats once famously noted, “Nothing ever becomes real till it is experienced.”
Modern finance theory usually assumes that people are fully rational, incorporating all available information instantaneously into their expectations. Yet researchers have discovered that our personal experiences disproportionately impact our expectations about the future and risk taking behavior. In other words, we often overweight our own personal experiences at the expense of broader and often more objective and accurate information.
Below, I examine the evidence behind, and implications of, this bad investing behavior, and what investors can do to try to overcome it.
Q: What is the evidence on how personal experiences affect our investment decisions?
A: Researchers have found that our experiences have a disproportionate impact on how much we save for retirement, our willingness to repurchase a given stock, our propensity to participate in initial public offerings and our portfolio diversification decisions.
Based on data from a large benefits recording firm, investors who have experienced high average returns or low volatility in their 401(k) accounts tend to save more. Meanwhile, as evidenced by trades during the 1990s at a large U.S. discount brokerage and a large retail brokerage, investors shun stocks that they previously sold for a loss and stocks that have risen in price after being sold. This is presumably because investors are trying to distance themselves from the associated negative feelings of regret and disappointment.
Our personal observations about the macroeconomic environment also impact our return and volatility expectations, risk taking and financing decisions. For instance, based on data from the Michigan Survey of Consumer Attitudes, individuals expect higher stock market returns and lower volatility in times of economic expansion than during recessions. In addition, corporate managers who experienced the Great Depression subsequently shied away from external financing and chose a more conservative capital structure with less leverage.
Finally, based on 1960 to 2007 data from the Survey of Consumer Finances, individuals who have experienced low stock market returns during their lifetimes tend to be more pessimistic about future returns, more risk averse, less likely to participate in the stock market and generally invest a lower fraction of their liquid wealth in stocks. The same is true for bond investors who have experienced low returns.
Q: What are the portfolio implications of this bad investing behavior?