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Investor Experiences and Financial Market Dynamics

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Investor Experiences and Financial Market Dynamics Journal of Financial Economics 136 (2020) 597–622 Contents lists available at ScienceDirect Journal of Financial Economics journal homepage: www.elsevier.com/locate/jfec R Investor experiences and financial market dynamics ∗ Ulrike Malmendier a,b, , Demian Pouzo c, Victoria Vanasco d a UC Berkeley, NBER, and CEPR, USA b Department of Economics and Haas School of Business, University of California, 501 Evans Hall, Berkeley, CA 94720-3880, USA c Department of Economics, University of California, 501 Evans Hall, Berkeley, CA 94720-3880, USA d CREI and BGSE, Ramon Trias Fargas 25–27, Barcelona 08005, Spain a r t i c l e i n f o a b s t r a c t Article history: How do macrofinancial shocks affect investor behavior and market dynamics? Recent ev- Received 4 June 2018 idence on experience effects suggests a long-lasting influence of personally experienced Revised 21 November 2018 outcomes on investor beliefs and investment but also significant differences across older Accepted 9 March 2019 and younger generations. We formalize experience-based learning in an overlapping gen- Available online 15 November 2019 erations (OLG) model, where different cross-cohort experiences generate persistent het- JEL classification: erogeneity in beliefs, portfolio choices, and trade. The model allows us to characterize a G11 novel link between investor demographics and the dependence of prices on past dividends G12 while also generating known features of asset prices, such as excess volatility and return G40 predictability. The model produces new implications for the cross-section of asset hold- G41 ings, trade volume, and investors’ heterogeneous responses to crises, which we show to be E7 in line with the data. Keywords: ©2019 Elsevier B.V. All rights reserved. Experience effects Learning Asset prices Portfolio choice Demographics 1. Introduction only for asset pricing puzzles, such as return predictabil- ity ( Campbell and Shiller, 1988; Fama and French, 1988 ) Recent crises in the stock and housing markets have and excess volatility ( LeRoy and Porter, 1981; Shiller, stimulated a new wave of macro-finance models of risk- 1981; LeRoy, 2006 ), but also for micro-level stylized facts taking. A key challenge, and motivation, has been to find such as investors chasing past performances. As argued tractable models of investor expectations that account not by Woodford (2013) , the empirical evidence suggests a need for dynamic models that go beyond the rational- expectations hypothesis. R We thank Marianne Andries, Nick Barberis, Dirk Bergemann, Julien In line with Woodford’s proposal, several emerging the- Cujean, Xavier Gabaix, Lawrence Jin, and workshop participants at LBS, ories feature agents who over-weigh recent realizations LSE, NYU, Pompeu Fabra, Stanford, UC Berkeley, as well as the ASSA, of the relevant economic variables when forming beliefs. 1 NBER EFG Behavioral Macro, NBER Behavioral Finance, SITE (psychology and economics segment), and SFB TR 15 (Tutzing, Germany) conferences Overweighing past realizations helps to successfully cap- for helpful comments. We also thank Felix Chopra, Marius Guenzel, Clint ture the above-mentioned asset pricing facts. However, as Hamilton, Canyao Liu, Leslie Shen, and Jonas Sobott for excellent research assistance. ∗ Corresponding author. E-mail addresses: [email protected] (U. Malmendier), 1 Examples are models of natural expectation formation ( Fuster et al., [email protected] (D. Pouzo), [email protected] (V. Vanasco). 2012; 2010 ) and over-extrapolation ( Barberis et al., 2015; 2018 ). https://doi.org/10.1016/j.jfineco.2019.11.002 0304-405X/© 2019 Elsevier B.V. All rights reserved. 598 U. Malmendier, D. Pouzo and V. Vanasco / Journal of Financial Economics 136 (2020) 597–622 the existing theories assume homogeneous overweighing This growing empirical literature on experience effects of realizations from the last year or couple of years, they and its strong psychological underpinning raise the ques- miss two important empirical patterns: first, macroeco- tion whether experience-based learning and the implied nomic shocks appear to alter investment and consump- dynamic cross-cohort differences have the potential to ex- tion behavior for decades to come, as conveyed by the plain aggregate dynamics. For example, which generations notion of “depression babies” or of the “deep scars” left invest in the stock market and how much? What are the by the 2008 financial crisis ( Blanchard, 2012; Malmendier dynamics of stock market investment? How do markets re- and Shen, 2018 ). In other words, the measurable impact of act to a macro-shock? past realizations goes far beyond the timeframe of existing Our paper develops an equilibrium model of asset mar- models. kets that formalizes experience-based learning and the re- Second, there is significant and predictable cross- sulting belief heterogeneity across investors. The model sectional heterogeneity. Younger cohorts tend to react sig- clarifies the channels through which past realizations af- nificantly more strongly to a recent shock than older co- fect future market outcomes by pinning down the effect horts, both for positive and for negative realizations. For on investors’ own belief formation and the interaction with example, in the above-mentioned case of “scarred con- other generations’ belief formation. We derive the aggre- sumption” ( Malmendier and Shen, 2018 ), periods of higher gate implications of learning from experience and the im- unemployment rates induces everybody to be more fru- plied cross-sectional differences in investor behavior. To gal, controlling for income, wealth, and unemployment sta- our knowledge, this model is the first to tease out the ten- tus, but the effect is particularly strong among younger co- sion between experience effects and recency bias. It aims horts. The reverse holds after times of economic booms, to provide a guide for testing to what extent experience- when consumers continue to spend more lavishly, particu- based learning can enhance our understanding of mar- larly the younger cohorts. ket dynamics and of the long-term effect of demographic A growing empirical literature on experience effects changes. shows both empirical patterns in numerous macrofinance The key model features are as follows. We consider a contexts. This literature emphasizes that the long-lasting stylized overlapping generations (OLG) equilibrium model. neuropsychology effects of personal “experience” is the key Agents have constant absolute risk aversion (CARA) prefer- mechanism at work. For example, personal lifetime expe- ences and live for a finite number of periods. During their riences in the stock market predict future willingness to lifetimes, they choose portfolios of a risky and a risk-free invest in the stock market ( Malmendier and Nagel, 2011 ), security. We assume that agents maximize their per-period and the same holds for the bond market and bond in- payoffs (i. e., are myopic). 5 The risky asset is in unit net vestment, for Initial Public Offering (IPO) experiences and supply and pays a random dividend every period. The risk- future IPO investment, and for inflation experiences and free asset is in infinitely elastic supply and pays a fixed fixed-rate mortgage choices ( Kaustia and Knüpfer, 2008; return. Investors do not know the true mean of dividends Chiang et al., 2011; Malmendier and Nagel, 2016 ). There but learn about it by observing the history of dividends. is also evidence of experience effects in nonfinance set- We begin by characterizing the benchmark economy in tings, e. g., on the long-term effects of graduating in a which agents know the true mean of dividends. In this set- recession on labor market outcomes ( Oreopoulos et al., ting, there is no heterogeneity, and thus the demands of 2012 ), or of living in (communist) East Germany to political all active market participants are equal and constant over attitudes postreunification ( Alesina and Fuchs-Schundeln, time. Furthermore, there is a unique no-bubble equilibrium 2007 ), 2 which in turn affect beliefs about communism ver- with constant prices. sus capitalism and explain east/west differences in stock We then introduce experience-based learning. The as- market investment ( Laudenbach et al., 2019a; 2019b ). sumed belief formation process captures the two main em- The overweighing of personal experiences appears to be pirical features of experience effects: first, agents over- a pervasive and robust psychological phenomenon affect- weigh their lifetime experiences. Second, their beliefs ex- ing belief formation, related to availability bias as first put hibit recency bias. We identify two channels through forward by Tversky and Kahneman (1974) as well as the which past dividends affect market outcomes. The first extensive evidence on the different effects of description channel is the belief formation process: shocks to divi- versus experience. 3 Much of the evidence on experience dends shape agents’ beliefs about future dividends. Hence, effects pertains directly to stated beliefs, e. g., beliefs about individual demands depend on personal experiences, and future stock returns (in the UBS/Gallup data), about future the equilibrium price is a function of the history of divi- inflation (in the Michigan Survey of Consumers, known as dends observed by the oldest market participant. the MSC), or about the outlook for durable consumption The second channel is the generation of cross-sectional (also in the MSC). 4 heterogeneity: different lifetime experiences generate per- 5 Myopic
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