Inflation is one of the most significant economic risks facing individual investors. Following the outbreak of the COVID-19 pandemic and the war in Ukraine, inflation resurfaced in many countries. Because of this rising inflation and the increasingly important role retail investors play in the capital markets, an increasing number of articles in the financial press discuss how retail investors could preserve the real value of their financial wealth in the face of rising prices, many of them pointing to equity investments.1 However, little is known about how individual investors actually react to the prospect of higher inflation, and theory provides conflicting assumptions on this issue. On the one hand, the hedging hypothesis predicts that investors more likely to buy and less likely to sell stocks when expected inflation rises. Indeed, investors understand that shares entitle them to a fraction of the income generated by the real underlying assets, which allows them to preserve the real value of their investments (e.g. Fama and Schwert 1977, Fama 1981, Boudoukh and Richardson 1993, Bekaert and Wang 2010). On the other hand, the money illusion hypothesis suggests that investors are less likely to buy and more likely to sell stocks in times of higher expected inflation. Indeed, they adjust nominal interest rates but ignore that corporate cash flows also increase with inflation, leading them to demand higher dividend yields to hold stocks (e.g. Modigliani and Cohn 1979 , Ritter and Warr 2002, Cohen et al. 2005). Given these two competing hypotheses, understanding how individual investors respond to expected inflation is an empirical question.
Germany in the 1920s as a laboratory
A test of individual investors’ response to inflation is subject to three main empirical challenges. First, it requires granular data on investors’ security transactions. This allows direct analysis of investment decisions in times of inflation. Second, there must be a period in which inflation, if ignored, produces considerable financial losses and thus attracts the attention of investors.2 Third, you need a reliable measure of expected inflation that varies both over time and across investors. This is a necessary condition for intra-individual analysis and helps to control the overall time trend.
This configuration is not available in the most common investor-level datasets. In a new study (Braggion et al. 2022), we introduce a unique dataset containing the securities portfolios of more than 2,000 private clients of a German bank between 1920 and 1924, the period of German hyperinflation. Data and time are ideally suited to address each of the empirical challenges described above. First, we have detailed information about every transaction executed by the bank’s clients, which allows direct analysis of the investment behavior of individuals. Second, inflation was high between January 1920 and September 1923, potentially leading to significant financial losses if ignored and no doubt attracting the attention of investors. Third, we have inflation data at a monthly frequency for hundreds of cities in Germany, which gives a measure of inflation that captures local observed inflation over time, which should be a reliable indicator of expected inflation.3
Individual investors buy fewer (sell more) stocks when faced with higher inflation
Figure 1 visualizes our main result. Each month, we classify the cities of Germany into deciles according to their local inflation and calculate, for each decile of inflation, the average buying-selling imbalance of the stock transactions of the clients residing in these cities. The buy-sell imbalance reflects the net demand for stocks from individual investors. We then plot the average buying-selling imbalances against inflation deciles. The figure shows a strong negative relationship between the two. This suggests that investors are buying less (selling more) stocks when faced with higher local inflation. Going from the decile with the lowest inflation to the decile with the highest inflation reduces the buying-selling imbalances by 17 percentage points. More formal regression-based analyzes confirm this result. Therefore, we find that investor behavior is consistent with the money illusion hypothesis but inconsistent with the hedging hypothesis.
Figure 1 Local inflation and stock market transactions
In additional tests, we find that the negative relationship between local inflation and buy-sell imbalances for equities is attenuated for more sophisticated clients. For our bank’s institutional clients, we even document a positive association between local inflation and buying-selling imbalances. These results support the idea that sophistication reduces money illusion.
We also find a positive relationship between local inflation and real returns lost to equity sales, suggesting that investors facing higher local inflation mistime their sales and suffer additional losses. This evidence is again consistent with investors making an inflation-induced investment error.
A large number of stress tests indicate that our conclusions are unlikely to be driven by investors using local inflation as an indicator of future economic performance, by investors’ risk aversion increasing with local inflation, by investors liquidating stocks to meet consumption needs and by investors moving to other asset classes that also offer inflation hedging.
Our analysis provides evidence that individual investors, especially the unsophisticated, make inflation-induced trading mistakes. This underscores the importance of the ongoing debate about individuals’ financial literacy. Recently, the European Commission highlighted low household financial literacy and called for making financial education a priority for Europe. Similar calls have been made in the United States.4 Our results underscore concerns that individuals’ financial literacy may not be sufficient to respond appropriately to currently resurfacing inflation.
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1 See, for example, “Inflation is coming. How much, for how long? », New York Times, June 6, 2021; “Inflation poses a duration problem for investors”, FinancialTimes, June 16, 2021; “Inflation could mean value stocks have time to shine,” The Wall Street Journal, October 26, 2021; “The Best Investments to Beat Inflation”, Forbes, December 28, 2021; “Flight to ‘safe haven’ funds carries its own risks”, Financial Times, March 7, 2022; “Equities as a hedge against inflation is a new catch-all narrative for market recovery”, Bloomberg, March 22, 2022.
2 In times of low inflation, investors may not react to inflation due to rational inattention (e.g. Mankiw and Reis 2002, Sims 2003, Katz et al. 2017).
3 Existing empirical work shows that personally experienced inflation is a crucial determinant of individuals’ inflation expectations (eg Malmendier and Nagel 2016, D’Acunto et al. 2021).
4 See, for example, “’We need people to know the ABCs of finance’: facing the financial literacy crisis”; FinancialTimes, October 4, 2021; “Education Secretary Miguel Cardona Says Personal Finance Classes Should Start ASAP,” CNBC, October 13, 2021; “Improving financial literacy must be a priority for Europe”, Financial Times, January 17, 2022.