Historically, stocks have produced greater returns than bonds, yet many investors have consistently shied away from stocks. In the long term, looking beyond the current recession, such prudence seems counterintuitive: average annual returns on S&P 500 stocks approached 12.5 percent between 1950 and 2008. During the same period, average annual returns on short-term bonds hovered around just 5 percent, while average annual return on long-term bonds was just over 6 percent.
Economists have traditionally attempted to explain why so many investors steer clear of stocks by assuming that those investors simply have very high levels of risk aversion. But some experts view such levels of risk aversion as unrealistically high.
More recently, some economists have taken a different approach using habit persistence models. In this newer view, investors’ choices, including their attitudes toward risk, are motivated by their own typical level of consumption (internal habit) and how that compares to that of their peers (external habit). A fast-food lunch gives much less pleasure to someone used to lunch in upscale restaurants than it does to someone used to fast food; a fast-food lunch falls below the threshold of her normal experience. Similarly, the pleasure or usefulness a person gets from a new handbag or TV depends in part on whether she views her purchases as measuring up to those of her peers.
Because of this dynamic, people tend to change their consumption behavior relatively slowly in response to actual or expected changes in income: a relatively poor person who inherits a lot of money is unlikely to immediately and drastically increase his spending. Instead, as he becomes increasingly comfortable with this newfound wealth, his spending will gradually increase.
When it comes to losing money, the dynamic shifts: the closer an investor finds himself to his own benchmark, the more he views himself as at risk to fall below it, and the more sensitive he becomes to risk. Once his net worth drops enough to threaten the lifestyle he’s accustomed to, he becomes much more conservative in his investing behavior.
Economists have looked to macro-data for an explanation of the connection between habit persistence, fluctuations in consumption and risk tolerance, and overall risk aversion, with mixed results. Professor Enrichetta Ravina, whose research interests include credit markets, behavior and household finance, turned to micro-level data for a clearer picture of the relationship between household consumption and investor behavior.
Ravina examined the consumption habits of 2,674 households in California over three years, using the credit card spending of individual households to assess their consumption benchmarks. To examine peer influence, Ravina looked for households in the same zip code that had quickly and noticeably increased their consumption, but whose income hadn’t increased. She then reviewed lottery winner data to see if that particular zip code had lottery winners of prizes of $200,000 or more. She found that households whose neighbors’ consumption increased the most were spending more than an otherwise similar individual, even after adjusting for other factors, including differences in the price of goods in the area, unemployment and house prices.
Unlike macro-data, micro-data offers the advantage of accounting for differences in consumer spending based on the unique financial circumstances of individual households, that is, whether each had more or less debt, access to additional credit, savings and how much. After accounting for those factors, Ravina was able to identify strong evidence that both the personal consumption and peer spending benchmarks informed habit persistence in the sample and that both benchmarks factored into spending choices to a high degree.
Ravina translated these findings into a model of risk appetite and compared that to risk appetite in the business cycle, finding that when uncertainty increases and investors experience significant negative wealth shocks, as they have recently, they exhibit disproportionate risk aversion. “Since investors’ consumption benchmarks and their relative positions compared to their peers are now at risk,” she says, ”they become extremely conservative in their investments, shying away from stocks.”
Enrichetta Ravina is assistant professor of finance and economics at Columbia Business School.