In recent years, interest rates reached historic lows in many countries. We document that individual investors “reach for yield,” that is, have a greater appetite for risk taking when interest rates are low. Using an investment experiment holding fixed risk premia and risks, we show that low interest rates lead to significantly higher allocations to risky assets, among MTurk subjects and HBS MBAs. This behavior cannot be easily explained by conventional portfolio choice theory or by institutional frictions. We then propose and test explanations related to investor psychology. We also present complementary evidence using historical data on household investment decisions.
We provide evidence that individual investors “reach for yield”, that is, have a greater appetite for risk taking in low interest rate environment (…) We find significantly higher allocations to risky assets in the low rate condition.
Experiments (N=400) with 2 groups, allocate $100.000 between ;
[groep 1] risk free = 5% vs risky asset = 10%
[groep 2] risk free = 1% vs risky asset =6% (investment horizon = 1 year).
We show that individuals demonstrate a stronger preference for risky assets in their investment decisions when the risk-free rate is low. (…) The difference is about 7 to 9 percentage points, on a basis of roughly 60% allocations to the risky asset.
Why? (what mechanisms?)
- People may form reference points of investment returns. we find that there is significant reaching for yield behavior when interest rates are below 3%, whereas investment decisions are not significantly different when interest rates are above this level. This cut-off seems consistent with the level of interest rates that most participants are used to prior to recent years
- Salience of the higher average returns on the risky asset in different interest rate environment. Most simply, 6% average returns relative to 1% risk-free returns is more salient than 10% average returns relative to 5% risk-free returns. Reaching for yield behavior is dampened if investment returns are completely framed in gross terms (e.g. instead of saying 5% returns, we say that one will get 1.05 units for every unit of investment).
In the 2017 version they made the graph that I had made myself in my 2016 summary:
Section 5: Suggestive Evidence from Observational Data: the data suggest that portfolio shares of stocks and flows into risky assets increase (while portfolio shares of safe assets and flows into deposits fall) when interest rates decrease. (p.28)
- In terms of magnitude, a one percentage point decrease in interest rates is associated with about 1.5 percentage points increase in allocations to stocks and a similar size fall in allocations to “cash”.
- Interestingly, the magnitude of allocations’ response to interest rates seems to be similar in the experiment and in the observational data. (p.29)
- We see that across different data sources, decreases in interest rates are associated with flows into risky assets and out of safe interest-bearing assets. (p30)
- we hold the findings in this section 5 to be merely suggestive and complementary to our experimental evidence, yet we are intrigued that data across several different sources show consistent patterns.
Other interesting bits:
- P1: A number of papers also provide empirical evidence that banks, money market mutual funds, and corporate bond mutual funds invest in riskier assets when interest rates are low (Maddaloni and Peydr_o, 2011; Jim_enez, Ongena, Peydr_o, and Saurina, 2014; Chodorow-Reich, 2014; Hanson and Stein, 2015; Choi and Kronlund, 2015; Di Maggio and Kacperczyk, 2016).
- footnote 1, p1: The \reaching for yield” behavior we study in this paper, most precisely, is that people invest more in risky assets when interest rates are low, holding constant the risks and excess returns of risky assets.
- Footnote 3, p5: For example, Di Maggio and Kacperczyk (2016) and Choi and Kronlund (2015) show that money market mutual funds and corporate fund mutual funds who reach for yield get larger in inflows, especially when interest rates are near zero. These inflows most likely come from yield seeking end investors. It seems plausible that households’ yield seeking behavior could be an important cause of some financial institutions reaching for yield.
- P5: our evidence on risk taking and interest rate environment may also have implications for security design and consumer protection, as households’ biases could be exploited by institutions and asset managers that highlight returns and shroud risks (C_el_erier and Vall_ee, 2016).
- P10-11 In our data, Harvard Business School MBAs and MTurk workers reach for yield by a similar degree. Nor do we find that reaching for yield declines with wealth, investment experience, or education among MTurks, or with investment and work experience in finance among MBAs
- P32 The impact of the interest rate environment on investor behavior could have important implications for connections between key macroeconomic issues and capital market dynamics and financial stability.