How A Recession Rewires Your Toleration For Risk

Aug 13, 2011

This past week the stock market took a serious nose-dive, the Dow Jones Industrial Average dropped 500 points on Thursday. As a result, investors across the board have been flocking to safer investments. Now you might expect older people to cash out in order to save their nest eggs — but young people? The standard investment advice would be to hold tight. Turns out, they're actually the ones fleeing from stocks the fastest.

UC Berkeley Economics Professor Ulrike Malmendier has been researching how big economic changes, such as a recession or depression, affect the way people invest. She says the past decade — with the tech bubble burst of 2000, the crash of 2008 and the plunge of this month — has made young people less likely to invest in the stock market.

"Your average lifetime experience so far has a strong predictive power on your willingness to take risk. So if you're born in a period where things are going badly, stagflation in the 70s or just the current financial crisis, you are very unlikely to be investing at all in the stock market, if so very little. Vice versa if it has been a boom period, the post-World War II boom or you know, during the tech bubble if only the good stuff happened to far."

Malmendier says the chaos in the markets now could have a long-term effect on young people.

"It takes about thirty years to go away, but then it does. So if somebody experienced the Great Depression in the twenties, in the fifties that person will actually not be as distinguishable from somebody who did not experience the Great Depression," she says.

What happens in the years following a depression or recession, Malmendier explains, is that the people affected actually think bad events are more likely to happen than they are. So if you give them a 50-50 gamble, they think it is really more like a 90-10 proposition and walk away.

"You attach the wrong probabilities to the outcome," she says.

Malmendier's says her research suggests that young people today are likely to invest very little, if at all, in the stock market for decades.

"This is drastic because despite all those ups and downs I think most financial economists would agree that a young person who is saving for the long-run should just have a broadly diversified portfolio, and this is not likely to happen at least for the next coming years," she says. "So the younger generation is really losing out in terms of the long-term preparation for when they have high expenses, family, ultimately retirement even."

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