What happens to investment choices when interest rates change? An experimental study

We study experimentally how subjects react to changes in interest rates. Our participants were asked to divide 1,000 units of currency between two assets – one risky and the other risk-free – in four different settings. We use different treatments to change the risk-free rate while keeping the risk premium constant. We find that risk-free rates affect risk allocation asymmetrically: subjects increase the risky portion in their portfolios in response to a decrease in rates. Still, they do not change their portfolios when rates rise. Furthermore, this asymmetric effect occurs only when interest rates remain constant over a relatively long duration; when they are volatile, their impact on risk allocation is reversed. We provide and test a behavioral explanation for these findings.