Low Interest Rates And Risk Taking: Evidence From Individual Investment Decisions
Chen Lian
Massachusetts Institute of Technology (MIT)
Yueran Ma
Harvard University
Carmen Wang
Harvard University – Department of Economics; HBS Negotiations, Organizations and Markets Unit
June 18, 2016
Abstract:
In recent years, many central banks have set benchmark interest rates to historic lows. In this paper, we provide evidence that individual investors “reach for yield”, that is, have a greater appetite for risk taking in such low interest rate environment. We first document this phenomenon in a simple investment experiment, where investment risks and risk premia are held constant. We find significantly higher allocations to risky assets in the low rate condition, among MTurks as well as HBS MBAs. This reaching for yield behavior is unrelated to institutional frictions, and cannot be easily explained by conventional portfolio choice theory. We then propose and provide evidence for two sets of explanations related to people’s preferences and psychology. We also present complementary evidence using historical data on individual investors’ portfolio allocations and household investment flows.
Low Interest Rates And Risk Taking: Evidence From Individual Investment Decisions – Introduction
In the past several years, central banks in major developed countries have set benchmark interest rates to historic lows. While ultra low interest rates aim to spur economic growth, they have raised concerns about unintended consequences. A major concern is “reaching for yield” in financial markets, which refers to the possibility that investors may have a greater appetite for risk taking, all else equal, when interest rates are low.1 This issue has important implications for understanding the impact of monetary policy on capital markets and financial stability.
Indeed, central bank leaders have frequently discussed reaching for yield in policy remarks. For example, in a 2013 speech, then Chairman of the Federal Reserve Ben Bernanke pointed out: “In light of the current low interest rate environment, we are watching particularly closely for instances of ‘reaching for yield’ and other forms of excessive risk taking, which may affect asset prices and their relationships with fundamentals (Bernanke, 2013).” Other top central bank officials such as Janet Yellen, Jeremy Stein, Raghu Rajan, etc. (Yellen, 2011; Stein, 2013; Rajan, 2013), as well as a large group of investors, have also publicly discussed their concerns about reaching for yield.
Despite its prominence, the issue of reaching for yield has not yet been thoroughly understood; its causes and mechanisms are still under investigation. A common perspective in recent research focuses on how institutional frictions may lead to reaching for yield. Some theories suggest that the nominal interest rate can affect banks’ capacity to buy risky assets by changing banks’ cost of leverage (Drechsler, Savov, and Schnabl, 2015), while others postulate that financial institutions’ risk taking may respond to interest rates due to agency problems (Feroli, Kashyap, Schoenholtz, and Shin, 2014; Morris and Shin, 2015; Acharya and Naqvi, 2015). 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 Peydro, 2011; Jimenez, Ongena, Peydro, and Saurina, 2014; Hanson and Stein, 2015; Chodorow-Reich, 2014; Di Maggio and Kacperczyk, 2016; Choi and Kronlund, 2015).
Yield seeking behavior, however, does not seem to be confined to institutions. Households and individual investors also appear to reach for yield in personal investment decisions. Some anecdotes suggest that savers have been frustrated with low interest rates in recent years, and often respond by shifting into riskier assets.2 This observation hints that institutional friction based explanations, while potentially quite important, may not be the entire story.
In this paper, we present evidence that reaching for yield could be partly driven by the way people perceive and evaluate return and risk trade-offs in different interest rate environment. It is significant even when people are investing for themselves, and may arise from preferences and psychology. Our observation points to reaching for yield as a robust phenomenon that is complementary to, yet may exist even in the absence of, institutional frictions. Our findings also suggest that investors’ propensity to reach for yield likely depends on the economic environment and their life experiences.
Specifically, we show that individuals demonstrate a stronger preference for risky assets in their investment decisions when the risk-free rate is low. We begin by documenting this phenomenon in a randomized experiment of investment decision making: in Treatment Group 1, participants consider investing between a risk-free asset with 5% returns and a risky asset with 10% average returns (the risky pay-offs are approximately normally distributed with 18% volatility); in Treatment Group 2, participants consider investing between a riskfree asset with 1% returns and a risky asset with 6% average returns (the risky pay-offs are again approximately normally distributed with 18% volatility). In other words, across the two treatment conditions, we keep the risk premium (i.e. average excess returns) and the risks of the risky asset fixed, and only make a downward shift in the level of returns. Participants are randomly assigned to one of the two treatment conditions. The investment decision in each treatment condition represents the simplest mean-variance analysis problem. Under conventional benchmark, people’s portfolio choice decision should not be significantly affected by the level of returns.
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