Why so Negative? Belief Formation and Risk Taking in Boom and Bust Markets

Abstract

What determines investors’ risk-taking across macroeconomic cycles? Researchers have proposed rational expectations models that introduce countercyclical risk aversion to generate the empirically observed time variation in risk-taking. We test whether systematic deviations from rational expectations can cause similar investment patterns without assuming unstable preferences. We let subjects form beliefs in learning environments which resemble characteristics of boom and bust markets, followed by an independent investment task. Subjects, who learned in bust market environments, form overly pessimistic beliefs and invest significantly less in an ambiguous investment option. However, we find no differences in a risky investment option, where expectations are fixed.

Keywords: risk-taking, belief formation, market cycles, return expectations

JEL Classification: D83, D84, E32, E44, G01, G11, G41