Formative Experiences and Portfolio Choice: Evidence from the Finnish Great Depression

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THE JOURNAL OF FINANCE VOL. LXXII, NO. 1 FEBRUARY 2017 Formative Experiences and Portfolio Choice: Evidence from the Finnish Great Depression SAMULI KNÜPFER, ELIAS RANTAPUSKA, and MATTI SARVIMÄKI ABSTRACT
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THE JOURNAL OF FINANCE VOL. LXXII, NO. 1 FEBRUARY 2017 Formative Experiences and Portfolio Choice: Evidence from the Finnish Great Depression SAMULI KNÜPFER, ELIAS RANTAPUSKA, and MATTI SARVIMÄKI ABSTRACT We trace the impact of formative experiences on portfolio choice. Plausibly exogenous variation in workers exposure to a depression allows us to identify the effects and a new estimation approach makes addressing wealth and income effects possible. We find that adversely affected workers are less likely to invest in risky assets. This result is robust to a number of control variables and it holds for individuals whose income, employment, and wealth were unaffected. The effects travel through social networks: individuals whose neighbors and family members experienced adverse circumstances also avoid risky investments. THE LARGE DEGREE OF HETEROGENEITY in how individuals construct financial portfolios poses a challenge for theory and empirical work. Studies of twins deepen the puzzle by showing that genetically inherited traits and family background cannot account for the variation in portfolio choice. Likewise, observable characteristics over and above genetic makeup and family environment do Samuli Knüpfer is with BI Norwegian Business School and CEPR. Elias Rantapuska is with Aalto University School of Business. Matti Sarvimäki is with Aalto University School of Business and VATT Institute for Economic Research. We thank Statistics Finland and the Finnish Tax Administration for providing us with the data. We are also grateful to Ashwini Agrawal, Shlomo Benartzi, Janis Berzins, David Cesarini, Joao Cocco, Henrik Cronqvist, Francisco Gomes, Harrison Hong, Kristiina Huttunen, Tullio Jappelli, Lena Jaroszek, Ron Kaniel, Markku Kaustia, Hyunseob Kim, Juhani Linnainmaa, Ulrike Malmendier, Stefan Nagel, Stijn Van Nieuwerburgh, Alessandro Previtero, Miikka Rokkanen, Clemens Sialm, Ken Singleton (Editor), Paolo Sodini, Robin Stitzing, Johan Walden, an Associate Editor, and two referees for insights that benefited this paper. Conference and seminar participants at the 4 Nations Cup 2013, American Economic Association Meetings 2014, China International Conference in Finance 2013, Conference of the European Association of Labour Economists 2013, Duisenberg Workshop in Behavioral Finance 2014, European Conference on Household Finance 2013, European Finance Association Meetings 2013, Helsinki Finance Summit 2013, Young Scholars Nordic Finance Workshop 2012, Aalto University, European Retail Investment Conference 2015, HECER, London Business School, Research Institute of Industrial Economics, Stockholm School of Economics, and University of California at Berkeley provided valuable comments and suggestions, and Antti Lehtinen provided excellent research assistance. We gratefully acknowledge financial support from the Emil Aaltonen Foundation, the Foundation for Economic Education, the Helsinki School of Economics Foundation, the NASDAQ OMX Nordic Foundation, and the OP-Pohjola Group Research Foundation. Earlier versions circulated under the title Labor Market Experiences and Portfolio Choice: Evidence from the Finnish Great Depression. The authors have read the Journal of Finance s disclosure policy and have no conflicts of interests to disclose. DOI: /jofi 134 The Journal of Finance R little to explain portfolio heterogeneity. 1 These patterns suggest the answers to the heterogeneity puzzle may lie in the events and circumstances individuals experience during their lifetimes. Experiences may influence portfolio choice through the formation of beliefs and preferences. Although psychologists and sociologists have long acknowledged that experiences can have a long-lasting impact on people (see Elder (1998) forareview),economistshaveonlyrecentlystartedinvestigatingthe impact of such formative experiences on financial decision making (Malmendier and Nagel (2011, 2016)). In this paper, we extend this line of research by investigating how formative experiences contribute to the large degree of heterogeneity in household portfolios. The Finnish Great Depression of the early 1990s, combined with rich register-based data, allows us to solve three challenges that plague attempts to identify the impact of formative experiences on portfolio choice. First, the events and circumstances people experience should relate to the formation of beliefs and preferences. We analyze how experiences of labor market distress influence long-run portfolio choice. Experiencing a job loss, facing difficulties in job search, and seeing other workers laid off can lead individuals to hold more pessimistic beliefs, reduce their appetite for risk, and shatter their trust in financial markets. 2 Second, individuals may experience different events and circumstances because they are different in ways that are unobservable to the econometrician. 3 Variation across local labor markets solves this identification problem. The depth of the Finnish Great Depression and its root causes the collapse of the Soviet Union in 1991 and a twin currency-banking crisis 4 meant many local labor markets experienced unexpected and severe disruptions. We show that the exposure to adverse labor market conditions is plausibly exogenous to worker characteristics and hence allows us to identify the impact of labor market experiences on portfolio choice. 1 Bertaut and Starr-McCluer (2002), Calvet, Campbell, and Sodini (2007), Curcuru et al. (2010), Guiso and Sodini (2013), Haliassos and Bertaut (1995), and Heaton and Lucas (2000) document portfolio heterogeneity. Barnea, Cronqvist, and Siegel (2010), Cesarini et al. (2010), and Calvet and Sodini (2013) use register-based twin data to analyze the determinants of portfolio choice. 2 During the 2007 to 2009 Great Recession, approximately one in six workers in the U.S. labor force experienced a job loss (Farber (2011)). Labor market distress was not solely confined to job losers: more than one-third of workers expressed anxiety about layoffs, wage cuts, shorter hours, and difficulties in finding a good job (Davis and von Wachter (2011)). 3 For example, more risk-averse individuals may experience fewer adverse events because they choose a safer environment, but at the same time their risk aversion makes them less likely to invest in risky assets. This behavior would generate a spurious positive correlation between adverse experiences and risky investment. 4 From 1991 to 1993, Finland s real Gross Domestic Product (GDP) fell by 10% and its unemployment rate rose quickly from 3% to 16%. The collapse of the Soviet Union in 1991 induced large output contraction in industries involved in barter trade between Finland and the USSR (Gorodnichenko, Mendoza, and Tesar (2012)). The export shock was amplified by a twin currency-banking crisis that is typically attributed to financial deregulation and credit expansion in the 1980s and to attempts to defend the currency peg (Honkapohja et al. (2009), Jonung, Kiander, and Vartia (2009), Gulan, Haavio, and Kilponen (2014)). Formative Experiences and Portfolio Choice 135 Third, experiences may not only influence portfolio choice through their effects on preferences and beliefs, but also affect other determinants of financial decisions, such as income and wealth. 5 Controlling for contemporaneous income and wealth does not necessarily solve this challenge because income and wealth are potential outcomes of labor market conditions (Angrist and Pischke (2009)). We develop an alternative approach that leverages the great amount of detail in the data to isolate experiences that likely do not correlate with wealth, income, or other determinants of portfolio choice. These settings analyze the influence of secondhand experiences gained through the network of an individual s neighbors and family members. Our measure of local labor market conditions stratifies the data according to each worker s region and occupation, and calculates how the rate of unemployment in each region-occupation cell changed compared to years prior to the depression. We then relate labor market conditions to investment in risky assets measured more than a decade after the depression. Importantly, the employment histories that feed into the calculation of labor market conditions and the asset holdings that determine our measure of investment in risky assets do not suffer from measurement error caused by recall biases in surveyed employment histories or by imprecise reporting of asset holdings. 6 Our way of measuring labor market experiences captures local labor market conditions that are unrelated to worker characteristics. Conditional on fixed effects for regions and occupations, a number of observable worker characteristics measured prior to the depression do not correlate with labor market experiences during the depression. Most importantly, labor market conditions during the depression do not relate to investment in risky assets prior to the depression. This falsification exercise suggests omitted variables are unlikely to explain our results. We find that experiences of adverse labor market conditions are associated with less long-term investment in risky assets. The estimates suggest the stock market participation rate, more than a decade after the depression, was 2.8 to 3.6 percentage points lower for workers who experienced a one-standarddeviation deterioration in labor market conditions. The t-values, clustered at the level of local labor markets, range from 5.9 to 6.0. This effect is large given that the unconditional stock market participation rate in our sample is 22%. The reductions in risky investment also extend to other asset classes. Adverse labor market conditions are associated with less investment in fixed income 5 These factors play a key role in determining risky investment in theories of household portfolio choice (see Campbell (2006) and Guiso and Sodini (2013) for reviews). 6 The main survey used to assess job losses in the United States, the Displaced Workers Survey (DWS), suffers from recall bias due to its long recall period (five years in the early years of the survey, three in the later years). For example, the number of displaced workers in 1987 is dramatically different when estimated based on answers to the January 1988 wave (2.3 million) and the January 1992 wave (1.3 million). See Appendix A in Congressional Budget Office (1993) and Evans and Leighton (1995). 136 The Journal of Finance R funds, balanced funds, and derivatives. These effects suggest labor market disruptions affect the extensive margin of having any risky investments. 7 Is the reduction in risky investment driven solely by changes in income, employment, and wealth accumulation? We examine this question by investigating the experiences of an individual s neighbors and family members. Because these secondhand experiences do not predict the individual s labor income, employment, or wealth accumulation in the data, other factors must be driving the effects on risky investment. The analyses of secondhand experiences suggest a reduction of 0.4 to 0.6 percentage points in risky investment for a one-standard-deviation worsening in the neighbors, siblings, and parents labor market conditions. Comparing these estimates to the magnitudes we obtain for firsthand experiences suggests at least 11% of the effect of labor market experiences on risky investment cannot be attributed to the wealth, income, and employment channels. We interpret this number as a lower bound because secondhand experiences likely exert less influence than personal firsthand experiences. Consistent with this conjecture, we find a reduction of 1.2 percentage points in regressions of firsthand experiences that explicitly control for postdepression labor market outcomes and wealth accumulation. Taken together, our findings lead us to conclude that labor market experiences, which are just one dimension of the many different events and circumstances individuals may experience, generate portfolio heterogeneity that individual-specific characteristics observable in a typical data set do not fully explain. More broadly, our results suggest that experiences can have a longterm impact on the formation of beliefs and preferences. Our paper relates to four strands of research. First, we contribute to the literature that studies how personal experiences influence investment decisions. Chiang et al. (2011), Choi et al. (2009), Kaustia and Knüpfer (2008), and Odean, Strahilevitz, and Barber (2011) analyzetherolepriorinvestmentexperiencesplayindetermininginitial public offering (IPO) subscriptions, retirement savings decisions, and stock purchases. These papers focus on relatively short-term experiences and do not address portfolio heterogeneity. In their analysis of cohort-specific macroeconomic experiences, Malmendier and Nagel (2011, 2016) find that the history of experienced stock returns and inflation is associated with investment decisions and beliefs. Our focus is different because we study the permanent mark labor market experiences leave on households financial portfolios. These experiences are measured from the cross-section of labor market conditions and thus vary within cohorts. This within-cohort variation can contribute to portfolio heterogeneity over and above any macroeconomic experiences captured by cohort effects. Nevertheless, when many workers share the same experiences, they can sideline large groups of individuals from participating in risky asset markets and generate systematic patterns in aggregate demand for risky assets. 7 We do not find an effect on the intensive margin: portfolio volatility, beta, and idiosyncratic risk are not reliably related to labor market experiences. The impact of labor market conditions on the extensive margin might mask the true effect on the intensive margin. Formative Experiences and Portfolio Choice 137 Second, we share a theme with the few papers that use data on twins to shed light on portfolio heterogeneity. Barnea, Cronqvist, and Siegel (2010) and Cesarini et al. (2010) showthat geneticfactors and familyenvironments explain only a small share of the variation in household portfolios. These papers point to experiences as a catch-all explanation for the remaining variation, whereas our paper measures specific experiences and investigates their impact on portfolio choice. The focus on labor market conditions and their long-term impact also sets our paper apart from Calvet and Sodini (2013), who use a twin design to estimate the relation between wealth and risky investment. Third, we add to the literature that studies intergenerational transmission of beliefs and attitudes toward risk. Charles and Hurst (2003) document positive parent-child correlations in wealth accumulation and stock market participation and Dohmen et al. (2012) reportsimilarcorrelationsinsurvey-based measures of risk attitudes and trust. Our results suggest that personal formative experiences whose consequences carry over to future generations may contribute to intergenerational correlations. In addition, our analyses of family members and neighbors suggest that the consequences of formative experiences may spread in the population through interpersonal information-sharing or observational learning. Finally, we contribute to the literature that studies the impact of labor market conditions on long-run earnings and unemployment (e.g., Jacobson, LaLonde, and Sullivan (1993), Oyer (2008), von Wachter, Song, and Manchester (2009), Couch and Placzek (2010), Kahn (2010), Davis and von Wachter (2011), Oreopoulos, von Wachter, and Heisz (2012)). Our paper adds a new dimension to the effects associated with living through adverse labor market conditions. The intergenerational results also relate to papers that study the impact of parents job losses on children s long-term outcomes (Bratberg, Nilsen, and Vaage (2008), Oreopoulos, Page, and Stevens (2008), Rege, Telle, and Votruba (2011)). The remainder of this paper is organized as follows. Section I introduces the timeline of the events, the data sources, and the empirical strategy. Section II presents results on the impact of firsthand labor market experiences on risky investment. Section IIIanalyzes the impact of secondhand labor market experiences. Section IV concludes. A. Timeline I. Timeline, Data, and Empirical Strategy This section details the timing of events and describes the measurement of the predepression control variables, labor market conditions, and postdepression outcomes. What were the main features of the Finnish Great Depression? Its scale was unusual: no other Organisation for Economic Co-operation and Development (OECD) country had experienced such a severe economic contraction since the 1930s. Figure 1 plots the real Gross Domestic Product (GDP) and unemployment rate from 1980 to Real GDP fell by 10%, and the unemployment rate increased from 3% to 16% between 1990 and Although 138 The Journal of Finance R Real GDP index (base year 1980) Real GDP Unemployment rate, % Unemployment rate, % Figure 1. Unemployment rate and real Gross Domestic Product (GDP) growth around the Finnish Great Depression. The graph depicts the annual rate of unemployment and annual real GDP in Finland from 1980 to The shaded area highlights the Finnish Great Depression from 1991 to GDP started to recover at the end of 1993, it reached its 1990 level only in The unemployment rate remained above 10% until The causes of the depression were twofold. First, the collapse of the Soviet Union in 1991 generated large output contraction. Gorodnichenko, Mendoza, and Tesar (2012) discuss why the collapse was so detrimental for Finland. Soviet trade accounted for about 20% of Finnish exports during the 1980s, with some industries, such as shipbuilding and railroad equipment manufacturing, exporting more than 80% of their goods to the USSR. The products exported to the USSR were often specialized and could not be sold easily to other countries (e.g., railroad equipment manufacturing using Russian track gauge). The overvalued terms of trade in the barter arrangements that exchanged the exported goods for oil and gas meant that the effective price of Soviet imports was significantly lower than their market price, resulting in an up-hike in energy prices when the Soviet Union collapsed. The trade shock was also largely unexpected. The Soviet Union cancelled the trade arrangements on December 6, 1990 without a transitional period and the Finnish firms did not seem to anticipate the shock. The second factor contributing to the depression was a twin currency-banking crisis (Honkapohja et al. (2009), Jonung, Kiander, and Vartia (2009)). A few years prior to the depression, regulation concerning domestic bank-lending rates was abolished, and foreign private borrowing was allowed. Finland s currency remained pegged, and foreign loans, which had significantly lower nominal interest rates, appeared attractive: 25% of new borrowing was in foreign currency. These policies led to a significant increase in capital inflows and bank lending, and while the economy was booming in the late 1980s, the financial sector became fragile. Formative Experiences and Portfolio Choice 139 Cohorts born Depression Portfolio choice Pre-depression controls Figure 2. Timeline of events and measurement. The sample consists of subjects born between 1950 and 1965 who are employed at the end of 1990 when the predepression controls are measured. Labor market conditions are measured during the 1991 to 1993 depression, and the portfolio choice variable comes from Attempts to moderate the boom and defend the currency peg against speculative attacks led to a sharp increase in real interest rates. The defense ultimately failed, with the currency devalued and floated in November 1991 and September 1992, respectively. Increases in debt burdens denominated in foreign currency trumped benefits to expo
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