| Abstract: |
We propose a novel explanation for classic international macro puzzles
regarding capital flows and portfolio investment, which builds on modern
macro-finance models of experience-based belief formation. Individual
experiences of past macroeconomic outcomes have been shown to exert a
long-lasting influence on beliefs about future realizations, and to explain
domestic stock-market investment. We argue that experience effects can explain
the tendency of investors to hold an over proportional fraction of their
equity wealth in domestic stocks (home bias), to invest in domestic equity
markets in periods of domestic crises (retrenchment), and to withdraw capital
from foreign equity markets in periods of foreign crises (fickleness).
Experience-based learning generates additional implications regarding the
strength of these puzzles in times of higher or lower economic activity and
depending on the demographic composition of market participants. We test and
confirm these predictions in the data. |