Does the Caveman Within Tell You How to Invest?
Changes in human biology across the seasons helps shape investment decisions.
Posted Aug 18, 2014
My co-authors and I recently published a paper proposing a rational theory of human behavior that helps explain both the “Sell in May, then go away” effect observed in risky stock markets and an opposing seasonal cycle observed in safe Treasury bond markets. The paper is a bit technical, but it can be summed up easily with reference to our caveman ancestors.
In this new study, we find that the historical patterns of stock and bond returns through the seasons implies not only seasonally changing investor risk aversion, but also seasonal changes in the way investors decide between consuming now versus saving for the future.
Enter the caveman. How does an examination of our ancestors help shed light on all of this? Back before we had light bulbs, freezers, microwaves, bank accounts, and other modern conveniences, life was a lot tougher. The likelihood of surviving another year was almost certainly enhanced by certain traits, such as willingness to save in the spring and summer so one could consume from stores of food in the fall and winter. If our ancestors had acted like the proverbial grasshopper during the spring and summer—wildly consuming instead of judiciously saving—the odds of surviving through the next fall and winter were certainly worsened, since they would be more likely to run short of food and other essential resources. Thus, saving instead of consuming during the spring and summer would be the preferred behavior for folks aiming to maximize the odds of survival. Additionally, by adopting cautious, “risk averse” habits through the fall and winter, hunkering down until the daylight rebounded, they would increase their odds of surviving through to the spring.
Today, these characteristics persist in all of us, including investors. We observe investors tending to flock away from risk in the fall, and returning in the spring. Similarly, in this new research study, we find evidence that investors are markedly more inclined to save (in all kinds of investment assets) than to consume in the spring and summer.
This work adds to our collective understanding of humans’ risk preferences, and how preferences translate into decisions and ultimately affect financial markets. What are the key takeaways? Be aware of the way the changing seasons can influence your mood and ultimately your behavior. Be cautious about making important financial decisions during particularly emotional times. Recognize that what might look like a great investment idea in the summer might not feel so appropriate once the winter doldrums set in, so try to build a portfolio that can endure the seasons. Investors who “buy and hold” tend to do better on average than those who trade frequently in an attempt to outperform the market. Accordingly, consider holding investments you’ll be comfortable holding through thick and thin.
The study, "Seasonally Varying Risk Preferences: Theoretical Foundations for an Empirical Regularity," was recently published in the Review of Asset Pricing Studies. The authors are Mark Kamstra, an associate professor at York University; Lisa Kramer, an associate professor at the University of Toronto; and Maurice Levi and Tan Wang, both professors at the University of British Columbia.