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

54 Pages Posted: 8 May 2020

See all articles by Pascal Kieren

Pascal Kieren

University of Mannheim

Jan Müller-Dethard

University of Mannheim

Martin Weber

University of Mannheim - Department of Banking and Finance

Multiple version iconThere are 2 versions of this paper

Date Written: April 2020

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. In this study, we test whether systematic deviations from rational expectations can cause the same observed investment pattern without assuming unstable risk preferences. We let subjects form beliefs in two different market environments which resemble key characteristics of boom and bust markets, followed by an independent investment task. Those subjects who learned in the negative domain form overly pessimistic beliefs and invest significantly less in an unrelated ambiguous investment option. However, similar investment patterns cannot be observed for an unrelated risky investment option, where expectations are fixed. The proposed mechanism presents an alternative explanation for time-varying risk-taking and provides new implications for both theory and policy makers.

Keywords: Belief formation, Market Cycles, Return Expectations, risk-taking

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

Suggested Citation

Kieren, Pascal and Müller-Dethard, Jan and Weber, Martin, Why so Negative? Belief Formation and Risk Taking in Boom and Bust Markets (April 2020). CEPR Discussion Paper No. DP14647, Available at SSRN: https://ssrn.com/abstract=3594278

Pascal Kieren (Contact Author)

University of Mannheim ( email )

Deparment of Finance, L9, 1-2
Mannheim, 68131
Germany

Jan Müller-Dethard

University of Mannheim ( email )

Department of Finance, L9, 1-2
Mannheim, 68131
Germany

Martin Weber

University of Mannheim - Department of Banking and Finance ( email )

D-68131 Mannheim
Germany
+49 621 181 1532 (Phone)
+49 621 181 1534 (Fax)

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