Will Recession Forever Scar Young Investors? (Money and Your Mind)

Published Oct. 23, 2009 at 4:00 a.m.

People who lived through the Great Depression were shaped thoroughly by the experience — so much so that many of them never gave up habits of extreme thrift, aversion to financial risk and even hoarding behavior.

As we begin the long climb out of the Great Recession, a question presents itself: How will this experience shape this generation’s minds and habits going forward?

A pair of recent studies may shed some light. The cognitive effects of financial shocks are long-lasting — and for those who go through them in early adulthood, can shape one’s entire outlook on life.

Take the findings of Paola Giuliano and Antonio Spilimbergo, presented in a recent National Bureau of Economic Research paper. Using data from the General Social Survey and matching it up with data on regional recessions in the United States between 1972 and 2006, the authors found that “individuals growing up during recessions tend to believe that success in life depends more on luck than on effort, support more government redistribution, but are less confident in public institutions.”

But what was truly striking was that this finding only held if the person was in his or her “formative years,” between 18 and 25, during the financial shock. Being exposed to a recession before the age of 17 or after the age of 25 had no effect in the data they studied.

How can this be? It’s not that people’s beliefs can’t change — and certainly not that an individual’s beliefs might not change. But social psychologists have found that humans, in the aggregate, are flexible and responsive to social circumstances when they’re young, but become far less flexible as they get older. Old dogs stick with the tricks they know.

To see just how substantially our experiences can influence our future behavior, take a look at another recent NBER paper. Ulrike Malmendier of the University of California, Berkeley and Stefan Nagel of Stanford University looked at the investment behavior of people who experienced the Great Depression in young adulthood. They found that these “Depression babies,” once they reached midlife, had only about a 13% participation rate in the stock market. Understandably, these folks were largely spooked out of the market for life.

By way of comparison, the cohort that came of age during the post-World War II boom, by the time they reached midlife, had a stock-market participation rate more than twice as high as that of the Depression babies.

And this pattern wasn’t restricted to the Great Depression; it applied to lesser shocks, as well. The paper finds that, in general, people who have lived through periods of bad stock market returns report lower willingness to take financial risk. They also are less likely to participate in the stock market, and, if they do invest in the stock market, invest a lower fraction of their liquid assets in stocks. (Similarly, people who have experienced high inflation are less likely to hold bonds.)

For example, young households in the early 1980s, having experienced the dismal stock returns of the 1970s, had low stock-market participation rates. For older households in the same period, however, the low returns of the 1970s were offset in their minds by their lifetime experience of having received high returns in the 1950s and 1960s.

Malmendier and Nagel found that this pattern flipped following the boom years of the 1990s. In this period, younger households recalled higher lifetime average returns and thus were more likely to participate in the stock market, allocated more to stocks, and reported lower risk aversion than older households.

The lesson: We’re slaves to what’s known as “availability bias.” We form our predictions about the world based on the data most readily available to us — on what’s happened to us personally, or what’s happened to our friends, or what we’ve read in the papers or seen on TV.

How scared should we be to fly? Statistically, the answer is “not very.” But, on takeoff, we’re still likely to think of any recent plane crashes we’ve seen on the news.

Our participation in the stock market seems to work in roughly the same way. If every investor were always looking at the totality of historical data, people’s heads would remain cool. But since we’re all hemmed in by the borders of our own experience, we make heated decisions based more on our own pasts than on any reasonable assumptions about the future.

Members of Generation Recession, however, might keep this in mind: By being caught up in the past, the Depression babies missed out on the boom market of the 1950s and 1960s. That doesn’t mean anyone should count on boom times ahead. Just that they should remember the past doesn’t always determine the future.

Ryan Sager writes the blog Neuroworld at TrueSlant.com.

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