How perceptions of macroeconomic disaster frequency influence our financial decisions

Do economic disasters, such as the Covid-19 crisis, have an impact on financial investment behavior? Are investors less inclined to invest after being burned by an extreme fall in asset values? At the heart of the analysis is the perceived frequency of macroeconomic disasters. The more we overestimate this frequency, the more cautious we are when making financial investments. But solutions exist!

Macroeconomic disasters are characterized by deep and persistent declines in gross domestic product (GDP) of more than 10% over an extended period. They are the result of wars, financial crises, pandemics, or climate disasters. Although they occur rarely, they have major repercussions on the global economy. Previous research has shown that these “rare disasters” play an important role in understanding the risk appetite of financial investors. However, the way in which economic actors perceive these disasters remains poorly understood.

This article explores perceptions of the frequency of macroeconomic disasters and how these perceptions influence financial investment decisions. It also analyzes the dissemination of information about past macroeconomic disasters, asking whether access to information enables individuals to better estimate the frequency of such disasters and to accordingly make more effective investment decisions.

Significant cognitive biases

The perception of rare events is subject to behavioral biases, due both to their rarity in economic history and to the impression they make on people when they occur. Before a disaster strikes, individuals often tend to underestimate the probability of such an event. But once a rare event has occurred, their perception of risk is often exaggerated, and they become convinced that new disasters are imminent.

This phenomenon can be explained by “recency bias”, a cognitive bias that places excessive importance on recent and salient events, as shown in the research of Tversky and Kahneman.

The Covid-19 crisis and its impact on the global economy have reignited interest in the study of macroeconomic disasters. The pandemic not only triggered a dramatic fall in financial markets, it also altered people’s perceptions of economic risk and affected their investment decisions. According to recent studies, people who suffered significant losses during the health crisis are more pessimistic about economic recovery and more inclined to avoid risky investments, leading to a significant decline in the performance of their savings.

Systematic overestimation of disasters

In order to better understand how individuals perceive the frequency of macroeconomic disasters, an experimental study with financial incentives was conducted in 2023-2024 with two groups of participants in France: 346 finance experts and 590 non-experts (laypersons) from the general population. The underlying idea for studying these two populations is that financial knowledge and practice could be important determinants of biases in individuals’ financial perceptions and decisions.

The historical frequency of macroeconomic disasters is defined in the study as the number of disaster episodes in a historical sample of more than 6,000 observations of real GDP per capita from 1870 to 2021 across 42 countries in different regions of the world. This sample is based on the historical dataset of Barro and Ursua (2008), updated to 2021, in which the probability of a disaster episode is 3% per year.

The results of the study showed that participants systematically overestimate the historical frequency of macroeconomic disasters. On average, laypersons estimated that the frequency of macroeconomic disasters in the historical data sample was 21.8%. Even experts overestimated the frequency of such disasters, with an average estimate of 15%.

Underinvestment in risky financial assets

This overestimation affected participants’ investment decisions. In a subsequent step, participants were asked to allocate a specified amount between a risk-free asset, which was certain to yield a low return, and a risky asset, which offered a high return in the absence of a macroeconomic disaster and a negative return in the event of a disaster. The possible occurrence of a disaster was determined by a random draw calibrated to the frequency of macroeconomic disasters in the historical sample.

The results show that overestimating the frequency of macroeconomic disasters led participants to underinvest in the risky asset, thereby reducing their gains.

The role of communication

Given this marked overestimation of the frequency of macroeconomic disasters by both groups of participants, a question arises: can communicating the actual frequency of these extreme events remedy an information problem or help correct errors in judgment and ultimately improve financial investment decision-making?

To answer this question, the study included three information treatments. The first involved informing participants that three macroeconomic disasters had been observed in a draw of 100 historical data points from the more than 6,000 observations in the database. The second provided participants with more precise information, indicating that 30 macroeconomic disasters had been observed in 1,000 historical data points. The third treatment was similar to the first, but also provided participants with a brief description of three specific, recent, and salient macroeconomic disasters: the Greek debt crisis (2008-2013) and the Covid-19 pandemic episodes in the United Kingdom and Spain (2020).

The purpose of this treatment was to test whether individuals react differently when they receive information about events that are close in time and location.

Revised perceptions

The results showed that providing participants with information on the historical frequency of macroeconomic disasters did indeed enable them to correctly revise their perception of this frequency. After receiving the information, both experts and laypersons revised their estimates downward, as shown in the two charts below. They then allocated a larger share of their investment to the risky asset.

Although the accuracy of the information provided did not have a significant impact on their revision of the estimated frequency of disasters, either for experts or for laypersons, information presented in a salient and concrete manner had a different impact on laypersons. The latter tended to give more weight to information about recent events, meaning that their downward estimate of the frequency of macroeconomic disasters was less pronounced after receiving this information compared with the other cases.

Implications for financial communication

The results of this study have important practical implications for financial communication. Communication about the historical frequency of macroeconomic disasters can significantly influence perceptions of this type of extreme risk, triggering a knock-on effect on financial investment decisions.

Providing quantitative information on macroeconomic disasters can improve investors’ perceptions and reduce the underinvestment observed in risky assets, particularly among laypersons. However, the impact of this communication depends on how the information is presented and the audience it targets. The accuracy of the information does not seem to be as important as the reference to salient and recent examples, particularly for the general public.