Investor Experiences and International Capital Flows

Document pages: 56 pages

Abstract: We propose a novel explanation for classic international macro puzzlesregarding capital flows and portfolio investment, which builds on modernmacro-finance models of experience-based belief formation. Individualexperiences of past macroeconomic outcomes have been shown to exert along-lasting influence on beliefs about future realizations, and to explaindomestic stock-market investment. We argue that experience effects can explainthe tendency of investors to hold an over proportional fraction of their equitywealth in domestic stocks (home bias), to invest in domestic equity markets inperiods of domestic crises (retrenchment), and to withdraw capital from foreignequity markets in periods of foreign crises (fickleness). Experience-basedlearning generates additional implications regarding the strength of thesepuzzles in times of higher or lower economic activity and depending on thedemographic composition of market participants. We test and confirm thesepredictions in the data.