Investor behavior has a lot to do with how markets behave, and with how investors perform. To profit from a long mega-bull market, investors have to be willing to buy stocks and hold them through the inevitable ups and downs along the way. Risk tolerance greatly influences their willing to do that—and risk tolerance is greatly influenced by their past experience.
From an article on risk in The Economist:
People’s financial history has a strong impact on their taste for risk. Looking at surveys of American household finances from 1960 to 2007, Ulrike Malmendier of the University of California at Berkeley and Stefan Nagel, now at the University of Michigan, found that people who experienced high returns on the stockmarket earlier in life were, years later, likelier to report a higher tolerance for risk, to own shares and to invest a bigger slice of their assets in shares.
But exposure to economic turmoil appears to dampen people’s appetite for risk irrespective of their personal financial losses. That is the conclusion of a paper by Samuli Knüpfer of London Business School and two co-authors. In the early 1990s a severe recession caused Finland’s GDP to sink by 10% and unemployment to soar from 3% to 16%. Using detailed data on tax, unemployment and military conscription, the authors were able to analyse the investment choices of those affected by Finland’s “Great Depression”. Controlling for age, education, gender and marital status, they found that those in occupations, industries and regions hit harder by unemployment were less likely to own stocks a decade later. Individuals’ personal misfortunes, however, could explain at most half of the variation in stock ownership, the authors reckon. They attribute the remainder to “changes in beliefs and preferences” that are not easily measured.
The same seems to be true for financial trauma. Luigi Guiso of the Einaudi Institute for Economics and Finance and two co-authors examined the investments of several hundred clients of a large Italian bank in 2007 and again in 2009 (ie, before and after the plunge in global stockmarkets). The authors also asked the clients about their attitudes towards risk and got them to play a game modelled on a television show in which they could either pocket a small but guaranteed prize or gamble on winning a bigger one. Risk aversion, by these measures, rose sharply after the crash, even among investors who had suffered no losses in the stockmarket. The reaction to the financial crisis, the authors conclude, looked less like a proportionate response to the losses suffered and “more like old-fashioned ‘panic’.”
I’ve bolded a couple of sections that I think are particularly interesting. Investors who came of age in the 1930s tended to have an aversion to stocks also—an aversion that caused them to miss the next mega-bull market in the 1950s. Today’s investors may be similarly traumatized, having just lived through two bear markets in the last decade or so.
Bull markets climb a wall of worry and today’s prospective investors are plenty worried. Evidence of this is how quickly risk-averse bond-buying picks up during even small corrections in the stock market. If history is any guide, investors could be overly cautious for a very long time.
Of course, I don’t know whether we’re going to have a mega-bull market for the next ten or fifteen years or not. Anything can happen. But it wouldn’t surprise me if the stock market does very well going forward—and it would surprise me even less if most investors miss out.