VoxEU Column Economic history Financial Markets

The ‘fear factor’: Personal experience and risk aversion in times of crisis

Human behaviour in times of financial crises is difficult to understand, but critical to policymaking. This column discusses new evidence showing that personal experience in financial markets can dramatically change risk tolerance. A cleanly identified historical episode demonstrates that even without losses, negative shocks not only modify risk appetite, but can also create ‘leverage cycles’. These, in turn, have the potential to make markets extremely fragile. Remarkably, those who witnessed this episode but were not directly threatened by it, did not change their own behaviour. Thus, personal experience can be a powerful determinant of investors’ actions and can eventually affect aggregate instability.

To paraphrase Larry Summers, some people are scared – just look around. The crisis of 2007–08 took a toll on a lot of people, investors included. What seemed to be a new age of steady, moderately high growth and stable equity returns suddenly turned into the biggest economic crisis since the 1930s:

  • Savers saw the value of their nesteggs plummet;
  • Unemployment shot up;
  • Firms that could borrow for next to nothing a few months earlier could not obtain financing for love or money.

Do shocks of this kind change attitudes? Does personal experience shape the way we view the world - and does this have major consequences in financial markets? Important recent research has shown that investors who lived through the Great Depression stayed away from equities all their lives; experiencing the high inflation environment of the 1970s influenced expectations of price changes in an important way (Malmendier and Nagel 2011, Malmendier, Tate, and Yan 2011, Malmendier and Nagel 2009). Similarly, Guiso, Sapienza, and Zingales (2011) show that when experimental subjects see a horror movie they subsequently become more risk-averse. They connect these findings to the behaviour of individual investors after the 2007–08 crisis.

These findings are important. Two further issues need to be resolved to show that personal experience can influence financial markets in an important way.

  • First, we need to know if experience itself – separate from the economic and financial consequences of the shocks in question – changes behaviour.
  • Second, it is important to demonstrate that these types of shocks to personal experience affect professional investors, and are large enough to influence market aggregate outcomes.
Experimenting with Angst

If the data fairy granted the social scientist one wish to resolve these outstanding issues, how would the ideal experiment look like? Ideally, we would want to observe a shock that differentially affects only some investors, and not others. Both groups should ex ante look as identical as possible. These players should be important in the sense that their behaviour can influence aggregate market outcomes. And the shock in question should not only affect just one group, it should also affect just one dimension – experience, leaving the actual financial or economic situation unchanged.

As it turns out, there is a real world setting that gets us very close to these ideal conditions – the crisis in the market for collateralized loans in 1770s Amsterdam. Just like in modern repo markets, speculators borrowed money against the stocks they were buying. The loans typically ran for 6 months, and they were secured against the assets being bought. Loans were typically big – on average, they amounted to 29,000 guilders. The finest pieces of real estate in Amsterdam – houses along the Herengracht Canal – sold for around 10,000 guilders. Interest rates were low, between 3 and 4%. Speculators had to put some of their own money down – around 20 % or so. In a new working paper, we explore what can be learned from lending in this setting (Koudijs and Voth 2014).

The people who lent in this market were mostly the richest 1% of Dutch society – rich widows and officials, retired merchants, etc. For each transaction, they had to decide how much money they were going to lend, and how much capital speculators had to come up with themselves. The bigger the latter – the ‘haircut’ on the loan – the less risk the lenders took.

Shock and famine

In 1772, things went wrong in a big way for one stock – the East India Company (Wilson 1941). After taking over Bengal and ruthlessly imposing additional taxes on the natives, a famine broke out, killing millions of the Company’s subjects. The famine also undermined the finances of the company. The stock price fell (from a prior peak at 270) to less than 150, with a sharp plunge from the final months of 1772. An investment syndicate organized by the Seppenwolde brothers entered the market at a price of 220. They were hoping that prices would rebound and they were willing to bet the house. They levered their position to the hilt. When prices collapsed is was ‘game over’. The syndicate failed to meet margin calls, and went bankrupt. Involved were some of the most illustrious names of the investment community at the time – such as the banking houses of Clifford and Ter Borch.

Lenders exposed to the syndicate looked identical to those who did not lend to the Seppenwoldes. A lender entered the market when unencumbered funds became available and he would be matched to a borrower that happened to need cash the exact same moment. The average haircut on most loans was 20%.

Figure 1. The East India Company’s Stock Price, 1720–1800

Source: Neal (1990).

Horror on Herengracht

Remarkably, when the Seppenwolde syndicate ran out of cash, not a single lender lost money. In line with legal requirements at the time, the collateral had been transferred to the lender right after the signing of the loan and Dutch rules ensured that the lenders could sell the securities as soon as a margin call went unanswered. They were not obliged to do so straight away. If the proceeds of the sale exceeded the value of the loan, lenders had to return the surplus to the estate of the bankrupt borrower. If there was a shortfall, they received a non-preferential claim on the bankrupt estate. In practice this meant that recovery was highly uncertain.

After the Seppenwolde syndicate defaulted, all lenders who had lent on the security of East India stock managed to recover the principal and interest payments. We painstakingly reconstructed all the transactions from 18th century notary records, and did not find a single case when there was a shortfall. In other words, lenders escaped without a scratch – except for the fright they received when the Seppenwoldes suddenly stopped paying.

How did this bad surprise affect investment behaviour? Previously, lenders to the Seppenwolde syndicate had lent at 20% haircuts, just like everyone else. Afterwards, they typically asked for 25 or even 30% – extraordinarily high levels. Many borrowers would have balked at these rates. That they borrowed at all with these exorbitant haircuts is due to the nature of the lending market. If a borrower needed cash, he typically didn't have many borrowers to choose from. Interestingly, we find no impact on the interest rates that were charged on these loans. The market apparently cleared through changes in haircuts alone.

Figure 2. Haircuts over time

The change in attitudes among lenders was so large – and it affected such a significant share of the group as a whole – that leverage in the market as a whole declined. Average haircuts for collateralized loans climbed from around 20 to 24%. Where one guilder of equity had previously sustained securities positions worth 5 guilders, it now only sufficed for 4. The Seppenwolde lenders’ changed behaviour made leverage ‘pro-cyclical’ – as stock prices fell, available leverage for speculators declined sharply. This exerted additional downward pressure on stock prices.

The crisis of the Seppenwoldes was no secret – it was all over the press. For example, the Amsterdam magazine De Koopman (The Merchant) observed with a sense of Schadenfreude: “One can only hope that reality will become more fashionable now [that] people are learning their lessons” (January 1773). The only reason why other investors did not do as the lenders to the syndicate did is that they didn't experience the same shock to their outlook on the safety of lending against collateralized securities.

We look at a number of alternative interpretations: direct effects of the collapse in East India stock prices, the breakdown of relationship lending or a change in borrower or lender characteristics. None of them is supported by the data. The only interpretation that seems plausible is that personal experience of potential losses changed perceptions of riskiness – and led to dramatically different behaviour.


In Robert Harris's novel The Fear Index, a hedge fund manager programs an algorithm that can predict panic in financial markets – a strategy that makes a mint for the fund owners and boffins involved until the computer overdevelops a mind of his own. The novel is pure fiction, but it raises the important question how changes in beliefs and risk tolerance influence financial market outcomes – and to what extent personal experience contributes to these changes.

We offer insight into one mechanism linking beliefs and risk tolerance by going back to Amsterdam's stock market 250 years ago. There, a temporary risk of losses – with no actual losses materializing – scared a large subgroup of lenders. This shock changed their behaviour and dragged down the market's overall credit availability. It created a ‘leverage cycle’ – a decline in lending just at the moment when the market went south. Pro-cyclical leverage cycles have the potential to make markets extremely fragile (Brunnermeier and Pedersen 2009). Remarkably, the lenders who did not have any exposure to the failing syndicate knew about the dangers threatening their peers – but they did not change their own behaviour. These results demonstrate that a personal ‘fear factor’ can be a powerful determinant of investors’ actions, and that it can play a crucial role in creating aggregate instability.


Brunnermeier, Markus, and Lasse Pedersen (2009), “Market Liquidity and Funding Liquidity”, Review of Financial Studies, 22(6): 2201–2238.

Guiso, Luigi, Paola Sapienza, and Luigi Zingales (2011), “Time Varying Risk Aversion”, working paper.

Koudijs, Peter, and Hans-Joachim Voth (2014), “Beliefs and Leverage: Personal Experience and Risk Taking in Margin Lending”, CEPR Discussion Paper.

Malmendier, Ulrike, and Stefan Nagel (2009), “Learning from Inflation Experiences”, unpublished manuscript, UC Berkeley.

Malmendier, Ulrike, and Stefan Nagel (2011), “Depression Babies: Do Macroeconomic Experiences Affect Risk Taking?”, Quarterly Journal of Economics, 126(1): 373–416.

Malmendier, Ulrike, Geoffrey Tate, and Jonathan Yan (2011), “Overconfidence and Early‐Life Experiences”, Journal of Finance, 66(5): 1687–1733.

Neal, Larry (1990), The Rise of Financial Capitalism, Cambridge; New York: Cambridge University Press.

Wilson, Charles (1941), Anglo-Dutch Commerce & Finance in the Eighteenth Century, Cambridge: Cambridge University Press.


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