With this contradiction in mind, the researchers designed a survey to compare investors’ thought processes with financial theory. In a simple experiment, they asked a wide range of investors, including sophisticated finance professionals, how they would invest a hypothetical $1,000 in the market.
Participants typically invested more in stocks when average stock returns were higher, and less when stocks were more volatile, which the researchers took as evidence that investors were considering risk and return. “Their reactions to changes in these two parameters are consistent with textbook logic,” the researchers write. “Participants understand their investment task and respond to some parameters in our experimental setup exactly as expected.”
However, the same textbook logic suggests that participants would notice and care about links between the timing of their investment returns and the economy’s health, which they did not. When asked why they invested the way they did, most participants said that they hadn’t considered the correlation between stock returns and consumption growth. Among those who did report thinking about this, three out of four wanted more stocks when returns were more correlated with consumption growth. Thus, there was more demand for stocks that were worse insurance and were more likely to lose value in a recession. That’s not in line with the theory of investors having an insurance mindset.
“Almost no one seems to pay attention to what academic finance has said is arguably the most important variable,” Hartzmark says.
Even with this fundamental premise of economic models in question, standard asset pricing models remain useful, the researchers write. A model doesn’t need to explain exactly how the world works to still make helpful predictions. Moreover, if investors aren’t using their portfolio as a hedge against a future downturn, it might be a good idea for them to consider.