Lars Lochstoer’s research demonstrates how the inexperienced, lacking historical context, impact markets
It’s not just musical tastes and a preference for texting rather than an old-school phone call that separate the young from their terribly unhip parents. A generation gap in how we internalize and react to market news is also at play.
Pierre Collin-Dufresne of Ecole polytechnique fédérale de Lausanne, Michael Johannes of Columbia Business School and UCLA Anderson’s Lars A. Lochstoer find that, in a world where younger investors are more impressionable than older investors, the restlessness of the young ones has portfolio implications for all of us.
The researchers build on studies that have established that younger investors tend to overreact to today’s news because they lack the historical context that brings a longer-term perspective. In their research, they find there is a price we all pay for the investing habits of the young. The reactiveness to current events by the young can cause stock prices to swing 20 percent higher (on good news) or lower (on bad news) than would be expected based on fundamentals.
In the heat of a good-news market shock, young investors adjust their expectations about future performance upward more than older investors. Same goes for the downside; after a crisis, younger investors will presume the future is going to be a continuation of crises and ratchet down their expectations more than the older generation that has lived through multiple shocks.
A lack of experience is to blame. If you’re an older investor, you and your 401(k) have been through plenty of ups and downs. You’re likely to bring all that personal experience to the table when deciding if and how to react to economic news. Younger investors have a far shallower reservoir of experience to tap.
For instance, the performance of Facebook, Amazon and Netflix might be an interesting Rorschach test across generations.
A younger investor might be inclined to assume that the sky will continue to be the limit for these outperformers, as they have been on a tear throughout this recent bull market that began in 2009. An old hand who was investing back in 2000 might temper her expectations, having experienced periods when high-flying tech got hammered. (We’re using Cisco Systems as the standard bearer for that meltdown.)
“The young generation suffer from a This Time Is Different bias as they treat their birth effectively as a structural break in terms of forming expectations about the future,” the researchers explain in “Asset Pricing When ‘This Time Is Different.’” “Because the young generation puts less weight on data they have not personally experienced relative to a fully Bayesian agent (one who considers all the data), they place greater weight on contemporaneous events than older agents (investors) when forming beliefs.”
The exuberance/despair of the young is not some inconsequential quirk. “The conditional asset pricing implications that arise from the experiential learning bias are large,” conclude Collin-Dufresne, Johannes and Lochstoer. The researchers’ model estimates that the gravitational pull of young investors’ reacting to recent events can cause market prices typically to be 20 percent over- or under-valued relative to what valuations might be based on pure fundamentals. Further, the added price risks induced by the experiential learning bias is a significant reason why investors demand high average returns to stock market investments relative to safe assets, offering a resolution to the so-called Equity Premium Puzzle. Studies have found investors insist on a premium return from stocks far in excess of the actual risk when compared to bonds.