Investor Behavior Over Business Cycles with Tacit and Endogenous Market Signals

Abstract

Investors often behave in puzzling ways. In this paper, we develop a theory that implies “unusual” investor behaviors in a market equilibrium with heterogeneous investors who formulate their investment strategies based on their individual assessments of market signals, where market signals are tacit information and endogenously dependent on the individual assessments. Tacit information requires experience and knowledge to interpret and understand. We find that (1) differences in investors’ knowledge, experience, risk attitudes and incomes can give rise to “unusual” investor behaviors under economic rationality; (2) investor behaviors are normal in normal periods, but abnormal in abnormal periods (a reversal of investor behaviors) when a swing market drives many inexperienced and highly risk-averse investors in and out of the market; (3) a change in the population shares of different types of investors in the market can cause a reversal of investor behaviors among those same types of investors; and (4) empirical evidence clearly supports our theory.