Ignorance, Fixed Costs, and the Stock Market Participation Puzzle (original) (raw)
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Stock market expectations and portfolio choice of American households. Work in progress
2008
Using survey data on expectations and the composition of household savings, this paper aims at explaining the stockholding puzzle: the low stock market participation despite high historical performance of stocks. We estimate a joint model of stockholding and survey answers, both based on stock market expectations. The estimated level of risk tolerance that links subjective beliefs to stockholding is moderate, supporting to the validity of our measures of subjective expectations. Heterogeneity in expectations leads to heterogeneity in stockholding, and low average expectations, high uncertainty, and large heterogeneity in expectations explain much of the stockholder puzzle. JEL Codes: D12, D8
Stock market expectations and portfolio choice of American households
2009
Abstract Using survey data on expectations and the composition of household savings, this paper aims at explaining the stockholding puzzle: the low stock market participation despite high historical performance of stocks. We estimate a joint model of stockholding and survey answers, both based on stock market expectations. The estimated level of risk tolerance that links subjective beliefs to stockholding is moderate, supporting to the validity of our measures of subjective expectations.
Financial literacy and stock market participation
Journal of Financial Economics, 2011
Individuals are increasingly put in charge of their financial security after retirement. Moreover, the supply of complex financial products has increased considerably over the years. However, we still have little or no information about whether individuals have the financial knowledge and skills to navigate this new financial environment. To better understand financial literacy and its relation to financial decision-making, we have devised two special modules for the DNB Household Survey. We have designed questions to measure numeracy and basic knowledge related to the working of inflation and interest rates, as well as questions to measure more advanced financial knowledge related to financial market instruments (stocks, bonds, and mutual funds). We evaluate the importance of financial literacy by studying its relation to the stock market: Are more financially knowledgeable individuals more likely to hold stocks? To assess the direction of causality, we make use of questions measuring financial knowledge before investing in the stock market. We find that, while the understanding of basic economic concepts related to inflation and interest rate compounding is far from perfect, it outperforms the limited knowledge of stocks and bonds, the concept of risk diversification, and the working of financial markets. We also find that the measurement of financial literacy is very sensitive to the wording of survey questions. This provides additional evidence for limited financial knowledge. Finally, we report evidence of an independent effect of financial literacy on stock market participation: Those who have low financial literacy are significantly less likely to invest in stocks.
Ambiguity Aversion and Stock Market Participation: Evidence from Fund Flows
RePEc: Research Papers in Economics, 2013
Stock market participation is very low, with approximately two thirds of all U.S. households not owning any public equity. This is a puzzle in the context of the basic Expected Utility model. One explanation put forward in the literature is that stock market participation is low because, in addition to risk, stocks also entail ambiguity and investors are ambiguity averse. We empirically test this hypothesis, measuring stock market participation using equity fund flows and ambiguity with dispersion in analyst forecasts about aggregate market returns. In a multivariate framework our results show that increases in ambiguity are significantly and negatively related to equity fund flows, and thus support the notion that limited market participation is related to ambiguity aversion.
Investor Sophistication and the Home Bias, Diversification, and Employer Stock Puzzles
SSRN Electronic Journal, 2000
Using data from the April 2005 Survey of Consumers, we develop an index of investor sophistication from a set of 14 quiz-like questions. We correlate our measure of sophistication with holdings of international investments, measures of diversification, and holdings of an employer's stock. We find that each of these variables is correlated with sophistication, with more sophisticated investors consistently behaving the way that financial economists would recommend. More sophisticated investors also appear more likely to participate in the stock market. We argue that since sophistication is correlated with each of these anomalous behaviors, the most likely explanation for each behavior is that unknowledgable investors simply make mistakes. We also regress sophistication on some simple measures of financial education, finding evidence that financial education is associated with greater sophistication.
Ignorance, Uncertainty, and Strategic Consumption-Portfolio Decisions
SSRN Electronic Journal, 2017
This paper constructs a recursive utility version of a canonical Merton (1971) model with uninsurable labor income and unknown income growth to study how the interaction between two types of uncertainty due to ignorance affects strategic consumption-portfolio rules and precautionary savings. Specifically, after solving the model explicitly, we theoretically and quantitatively explore (i) how these ignorance-induced uncertainties interact with intertemporal substitution, risk aversion, and the correlation between the equity return and labor income, and (ii) how they jointly affect strategic asset allocation, precautionary savings, and the equilibrium asset returns. Furthermore, we use data to test our model's predictions on the relationship between ignorance and asset allocation and quantitatively show that the interaction between the two types of uncertainty is the key to explain the data. Finally, we find that the welfare costs of ignorance can be very large.
Stockholding and stock market beliefs of American households over the business cycle
2011
Abstract We use household panel data from the Health and Retirement Study to estimate the effect of changes to stock market prices on householdsjportfolio composition, and the role of changes in beliefs in such effects. Our estimates imply that many households react to changes in stock prices in the previous two years by actively adjusting the share of stock% market based assets in their portfolios. On average, the effect exceeds the passive adjustment that changes in stock prices would imply.
2018
Based on the life-cycle and permanent income hypothesis, to maintain their utility, households prefer to smooth consumption over their lifetimes by accumulating assets (Ando & Modigliani, 1963). The main proposition of the hypothesis is that households’ consumption should not be correlated with expected income growth. Contrary to this theory, McCarthy (2004) found empirical evidence that individuals do respond to expected income growth when they consume and save. How can we fill this gap between the theoretical predictions and empirical findings? Deaton (1991) answered this question by incorporating a new component of income streams, uninsured income risks. That is, when saving, households react not only to expected income growth, but also to the variance in expected income growth (income risks). To buffer their risks, rational households decrease their demand for risky assets in their investments if they face uninsured income uncertainty (Bertaut & Haliassos, 1997). In order to tes...
Risk Taking, Diversification Behavior and Financial Literacy of Individual Investors
This research investigates whether the financial literacy of individuals influences risk taking decisions and diversification behavior. This issue is relevant in that investors are increasingly in charge of their own financial security, but they have to deal with financial instruments whose increasing complexity often eventually prevents them from making conscious investment decisions.Prior empirical evidence shows that people are unable to perform a “sophisticated” portfolio diversification: what they do is to split equally their wealth among the asset classes available, in a naïve way. We try to detect if the financial literacy is a driver of this kind of decisions.By submitting a questionnaire to 200 American individuals, we find that financial literacy plays a role in risk taking decisions, positively affecting how much risk individuals are willing to take. Moreover, only those who are literate in terms of diversification select less risky portfolios; the others merely increase ...
Financial Illiteracy and Stock Market Participation: Evidence from the RAND American Life Panel
SSRN Electronic Journal, 2010
Financially illiterate households who consistently make suboptimal decisions may suffer lasting consequences for long-term wealth accumulation. This is particularly true for the US population given institutional changes shifting the burden of postretirement planning to the individual via the spread of defined contribution (DC) pension plans, leaving those who do not plan for retirement with lower net wealth (Lusardi and Mitchell, 2006, 2007). This population is also increasingly diversified, with a growing number of foreign-born households that face further language, educational, and cultural barriers to entry into formal financial systems (Braunstein and Welch, 2002). Many public and private stakeholders-including the federal government, nonprofit groups, and employers-have responded by supplying more education and tools for planning, under the implicit assumption that increases in financial literacy will lead to changes in behavior. Evidence regarding the impact of financial illiteracy on financial behavior, however, has been both scarce and mixed (e.g., Martin, 2007; Agarwal et al., 2011). One reason for these limitations is that a substantial fraction of existing studies that address this question are based on the evaluation of specific financial education programs and policies. Bayer et al. (1996) and Bernheim et al. (2001) showed that employer-based financial education increases participation in saving plans, while financial education mandates in high school significantly increase adult propensity to save. Recently, however, other researchers (e.g., Duflo and Saez, 2003; Cole and Shastry, 2009) have found surprisingly small impacts of financial education programs on financial decision-making, particularly in comparison to other factors, such as peer effects and psychological biases. Yet detecting effects of financial literacy in such analyses is problematic: in addition to questions about external validity and program heterogenity, the observed efficacy of such programs depends on not one but two relationships: the ability of the program to affect literacy, and the effect of literacy on behavior. Further,