A Retrieved-Context Theory of Financial Decisions

Abstract

Studies of human memory indicate that features of an event evoke memories of prior associated contextual states, which in turn become associated with the current event’s features. This retrieved-context mechanism allows the remote past to influence the present, even as agents gradually update their beliefs about their environment. We apply a version of retrieved-context theory, drawn from the literature on human memory, to explain three types of evidence in the financial economics literature: the role of early-life experience in shaping investment choices, occurrence of financial crises, and the impact of fear on asset allocation. These applications suggest a recasting of neoclassical rational expectations in terms of beliefs as governed by principles of human memory.