DP14647 Why so Negative? Belief Formation and Risk Taking in Boom and Bust Markets

Author(s):	Pascal Kieren, Jan Mueller-Dethard, Martin Weber
Publication Date:	April 2020
Keyword(s):	Belief formation, Market Cycles, Return Expectations, risk-taking
JEL(s):	D83, D84, E32, E44, G01, G11, G41
Programme Areas:	Financial Economics
Link to this Page:	cepr.org/active/publications/discussion_papers/dp.php?dpno=14647

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.