- Past returns influence today’s investment decisions
- Will this lead investors away from balanced portfolios?
Investing is a forward-looking business: how will a position perform in the future? Will my portfolio meet its long-term goals? Yet research suggests that we could make better decisions if we spent a bit more time looking backwards: the returns we experienced in the past have a lingering influence on the investment decisions we make today.
In 2010, economists Ulrike Malmendier and Stefan Nagel studied the literature regarding people who had lived through the Great Depression. Their work, and that of the studies they examined, showed that the returns experienced over the course of an individual’s life shaped their willingness to take financial risk. Crucially, these experiences had an even bigger impact than historical facts, or information gleaned from other sources: what people knew in theory exerted a far weaker influence than the things they had witnessed themselves.
This matters. Someone who has been investing since 2020 has already weathered the pandemic, the crypto 'winter' and the vertiginous ascent of interest rates; someone investing since 1980 can add Black Monday, the bursting of the dotcom bubble and the 2008 financial crisis to the list, to take the three most obvious examples. It seems only reasonable to assume that these experiences shape us as investors.
Our experiences shape which assets we invest in
The research seems to bear this out. Malmendier and Nagel found that a 5 percentage point increase in the level of real equity returns saw investors increase their allocation to stocks by about 7 percentage points. Higher experienced stock returns were also associated with more optimistic beliefs about future stock market performance.
On the flipside, people who experienced low bond returns were less likely to invest in bonds – even when controlling for age and other household characteristics. The same, unsurprisingly, was true for shares.
The research also found that although our past experiences influence us, more recent ones hold the most power. This is particularly true for younger investors who, after all, have shorter ‘life-time histories’. As the chart below shows, someone investing since 2020 has seen high (albeit volatile) stock market returns, and the worst period for bonds in living memory. Investors with a longer ‘life-time history’ have very different reference points, as the table illustrates .
| Average historical returns over investment horizon | ||
|---|---|---|
Stocks (S&P 500 including dividends), % | Bonds (US 10 year Treasury), % | |
2020s | 13.6 | -1.8 |
2010s | 14.0 | 4.4 |
2000s | 1.2 | 6.6 |
1990s | 18.8 | 7.8 |
1980s | 18.0 | 12.6 |
1970s | 7.5 | 5.6 |
1960s | 8.6 | 2.5 |
1950s | 20.9 | 0.8 |
1940s | 9.6 | 2.5 |
1930s | 4.3 | 4.0 |
| Source: NYU Stern | ||
Gen Z investors are not flocking to bonds: Nasdaq data suggests that, while almost three-quarters own individual stocks, only 30 per cent hold any kind of bond investment. Even if younger investors are well aware that – in theory – a balanced portfolio plays a crucial role in smoothing out investment returns, recent experience might be enough to persuade them otherwise.
If past experiences impact how we invest, it seems only natural to look at how the effects of the pandemic might influence our decisions today. Past research suggests that after terror attacks (which, like a pandemic, spread fear and disrupt day-to-day life), demand for risky assets declines. But this doesn’t quite stack up with our experience of lockdowns: the pandemic period saw huge inflows into crypto assets and well-publicised meme stocks. This could be explained by the fact that the pandemic also came with a heavy dose of boredom.
Economist Regina Ortmann found that investors significantly increased their trading activity as the pandemic unfolded: a 100 per cent increase in Covid cases was associated with a 14 per cent increase in trading intensity. With large swathes of the economy shuttered, and opportunities for fun severely limited, investors turned to trading as a source of entertainment.
Echos of this linger today. In the UK, 55 per cent of young investors report ‘curiosity’ as a top motivation for investing, while 43 per cent list a fear of missing out. But if this pushes investors towards more ‘exciting’ investments such as crypto (held by 50 per cent of Gen Z investors as of late 2022) or NFTs (held by a quarter as of that date), it could make for risky or badly diversified portfolios. We like to think that expected future returns shape our investment decisions. Research suggests that past experience does, too.
