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Trapped by our past

Our investment decisions are determined not just by current realities but also by our formative years.
Trapped by our past

Our investment decisions are shaped not just by current realities but by our own personal histories, according to new research.

The University of Cambridge’s Raghavendra Rau and colleagues studied over 2,000 US fund managers and found that those who as children had seen their parents divorce or one of them die took less risk with their portfolios and were more likely to sell winning stocks than fund managers who had grown up in two-parent families.

This is perhaps because the loss of a parent when you are young makes you more anxious even later in life, which makes you less willing to take risk and quicker to crystallise profits on a stock by selling. This holds true even controlling for the fund managers’ age, place of birth and parental occupation.

This doesn’t make investors from single-parent families worse than other ones: Dr Rau found no difference in returns, perhaps because the profits from having more defensive stocks offset the tendency to sell winners and so miss out on momentum. It just makes them different.

What we have here then is clear evidence that even experts’ decisions are swayed not just by relevant current facts but also by their personal history – which is one reason why people with the same information and similar training make different choices.

And it is by no means the only evidence we have here. Ulrike Malmendier at the University of California at Berkeley has show that CEOs who grew up in a recession run their companies with less debt than others, and that FOMC members who experienced high inflation in their younger days forecast higher inflation when setting interest rates. She has also shown that people who experienced recession in their formative years hold fewer equities than others even decades later.

Erin McGuire at the University of Arizona has shown that people who grew up in poorer US states hold fewer equities years later even controlling for current income and wealth.

And the University of Miami’s Henrik Cronqvist has found that people who grew up in poverty or who experienced a recession in their formative years are more likely to become value investors years later.

Ben Graham, who is regarded as the father of value investing, fits this pattern. He grew up in a poor home having lost his father – experiences which might well have predisposed him to seek the apparent security of big dividends. Rather less notably, your correspondent’s high cash weightings and caution about the market might be related to the fact that his parents split up when he was young.

Napoleon Bonaparte, then, was right: “to understand the man you have to know what was happening in the world when he was twenty.” The 20-year-old who has seen divorce, death, poverty or recession is a different man to the one who hasn’t.

Investors should therefore be more introspective. We should ask whether our attitudes to risk and to the relative merits of defensive or value stocks against growth stocks are based on objective facts or rather upon our upbringings. Strictly speaking, of course, the latter are irrelevant: the market will fall or not and value stocks will do well or not regardless of our life history.

We should also read macroeconomic forecasts in this light.

We cannot yet know for sure how much damage last year’s recession has done to the supply-side of the economy, or the extent to which it has permanently changed our spending habits. Economic models which have been calibrated upon a pandemic-free world might therefore be unreliable, and so we must use our judgement.

But of course our judgement is shaped by our personal history. Somebody in their 60s or 70s has vivid memories of the high inflation of the 1970s. This predisposes them to think that high inflation is if not normal then at least possible, which makes them more likely to be inflation hawks. By contrast, people under 40 who have spent their lives in western economies have little personal experience of significant inflation and so many are more likely to take low and stable inflation for granted. (An exception to this might be crypto-currency enthusiasts, but that’s a different story.)

One of these generations will be proved right in the next few years. For many of them, though, this will be a happy accident rather than the result of their excellent analysis. (Not that they’ll see it that way of course.)

All this means our expectations should be lightly held because they might well be coloured by irrelevant facts: whatever happens to inflation, it won’t be because of how vivid or not are your memories of the 1970s.

The old advice that we must base our investments upon the range of possible outcomes rather than upon a single forecast is therefore perhaps even more true than ever before.

You might wonder where this leaves the theory of rational expectations, the idea that our forecasts embody all relevant information and so are not systematically mistaken. It leaves it dead, that’s where.