Danger of the Post-Crisis Mentality

“Many younger investors suffered losses during the crisis (2007-2009)… Perversely, this caused them to endanger future retirement goals by sacrificing returns (through) underinvesting in risky assets.” — Joseph V. Rizzi: “Post-Crisis Investment Behavior: Experience Matters” in Investment Behavior; edited by H Kent Baker and Victor Ricciardi (Wiley, 2014).

Credit Suisse reports that measureable indicators of investor risk appetite are at a modern low. In fact, its market focus suggests that stockholders’ appetite for risk may be more depressed than it has been in the last 25 to 30 years. This pessimistic view is not only related to economic, political and world outlook views. It is also linked to the recent memory of investors.

When we make a financial decision, we tend to give extra weight to information that is easy to recall. Recent events are in that category.

For example, the stock market crisis of 2007-2009. Psychologists explain this phenomenon using the technical terms, behavioral memory bias and the availability heuristic. Behavioral memory bias refers to acting on recent information more heavily. Availability heuristic is a mental shortcut that occurs when people make judgments about the probability of events by how easy it is to think of examples. The two are placed in the category of a cognitive bias or a propensity to think in specific ways.

Studies show that younger investors are affected more than older counterparts by the recent crisis, probably because the time period is a relatively higher percentage of their total investing experience compared to older individuals.

Malmendier and Nagel (2012) even went so far as to suggest that the financial crisis may have produced a lost generation of younger investors who will be so risk averse in their investment choices that their portfolios will not keep up with inflation. If so, this would be tragic as it is shareholders in this age group who have the best chance of recouping losses over time simply because they have more years in which to invest. Therefore, traditional wisdom suggests they can take greater risks.

A well-funded retirement may be just a dream for many investors.

Unfortunately, though, the shock of a financial crisis and consequent behavior resulting from it can last decades. Antti Ilmanen wrote in Expected Returns: An Investor’s Guide to Harvesting Market Returns (Wiley, 2011) that distrust of the market is only slowly chipped away from memory. In fact, after the Depression, distrust did not totally ablate until the 1960s.

It seems that investors were too optimistic before the 2007-2009 crisis and now are too pessimistic in the aftermath. The young are particularly affected. Although caution is always warranted, and it is traditionally best to avoid placing money in risky investments that individuals can’t afford to lose, recent psychological insights are going beyond this in explaining investor behavior. Behavioral memory bias and the availability heuristic help explain why shareholders do what they do. This knowledge can only help investors make better decisions going forward.

In conclusion, stockholders, and especially those who are younger, might want to consider the risk they take by not taking any risk. The downside is that inflation could well be greater than their investment returns. Then, they won’t have as much money as they need for retirement, a sad conclusion after a life spent working hard.

For Further Reading:

Joseph V. Rizzi: “Post-Crisis Investment Behavior: Experience Matters” in Investment Behavior edited by H Kent Baker and Victor Ricciardi (Wiley, 2014). The chapter is a good source of information on investor behavior after the 2007-2009 crisis.