Risk-Taking and Asymmetric Learning in Boom and Bust Markets
Pascal Kieren, Jan Müller-Dethard, Martin Weber
Review of Finance, Volume 27, Issue 5, September 2023, Pages 1743–1779, https://doi.org/10.1093/rof/rfac072
One of the major puzzles in financial economics is the predictably counter-cyclical nature of the equity risk premium. A key assumption in models that generate time-variation in the equity premium is that investors have rational (and as such counter-cyclical) expectations, which are immediately updated according to Bayes’ rule when new information arrives (Barberis, Huang, and Santos, 2001; Campbell and Cochrane, 1999; Grossman and Shiller, 1981). Yet, a number of recent surveys of investors’ expectations show that this is not the case, and that investors – if anything – have rather pro-cyclical expectations: they are more optimistic in boom markets and less optimistic in recessions (Amromin and Sharpe, 2013; Giglio et al., 2020; Greenwood and Shleifer 2014).
In the light of this inconsistency, it is imperative to obtain a deeper understanding of how investors form expectations across boom and bust markets, and whether this could ultimately explain observed differences in risk-taking. In this paper, we provide direct experimental evidence for the role of expectations for investors’ risk-taking behavior across macroeconomic cycles. In an experiment, we can establish a setting in which we have direct control over objective (rational) expectations and can compare them to participants’ subjective beliefs. This allows us to document systematic errors in the belief formation process, which we can then relate to the subjects’ investment choice.
We show that individuals’ exposure to different market regimes systematically biases how they process information. Conditional on observing the same information, individuals who learn in bust market environments form significantly more pessimistic beliefs than those who learn in boom market environments. The difference in beliefs subsequently translates to a lower willingness to take risk. Additionally, we provide evidence for a specific mechanism behind the asymmetric learning across market phases. We show that investors in bust markets appear to put significantly more weight on unfavorable outcomes when updating their expectations compared to investors in boom markets. This difference in learning is especially pronounced in situations in which new information is at odds with existing expectations.
Overall, our results are in line with recent survey evidence on investors’ return expectations being pro-cyclical and provide a micro foundation for why this is the case. The documented asymmetry in investors’ learning may generate self-reinforcing feedback loops which amplify the intensity and the length of market cycles. For example, subsequent declines in stock prices that render investors to form overly pessimistic expectations, could lead to an increased number of sales which pushes prices further down