A Theory of Experience Effects

How does the experience of a financial crisis and other macroeconomic shocks alter the dynamics of financial markets? Recent evidence suggests that individuals overweight personal experiences of macroeconomic shocks when forming beliefs about risky outcomes and making investment and borrowing decisions. We propose a simple OLG model as a theoretical underpinning of experience-based learning. Risk averse investors invest in a `Lucas tree’ and a risk-free asset. They form beliefs based on data observed during their lifetime so far. We show that, in equilibrium, prices depend only on the dividends observed by the generations that are alive, and are more sensitive to more recent dividends. Younger generations react more strongly to recent experiences than older generations and, hence, have higher demand for the risky asset in good times, and lower demand in bad times. The model has implications for stock prices and trading volume. First, the more agents rely on recent observations, the more volatile are prices and the higher is the autocorrelation. Second, the stronger the disagreement across generations (e.g., after a recent shock), the higher is the trade volume. The model implies that the composition and past experiences of a population experiencing a financial crisis strongly affect its long-run effects.