Limited Household Participation in the Stock Market Phenomenon Analysis

LIMITED HOUSEHOLD PARTICIPATION IN THE STOCK MARKET PHENOMENON ANALYSIS TABLE OF CONTENTS 1. INTRODUCTION3 2. FACTORS THAT DETERMINE STOCKHOLDING DECISION OF HOUSEHOLDS4 2. 1. Wealth4 2. 2. Intelligence quotient (IQ) and cognitive skills4 2. 3. Education4 2. 4. Country4 2. 5. Information availability and ease to trade6 2. 6. Market trust6 2. 7. Age7 2. 8. Marital status7 2. 9. Sociability (social interaction)8 2. 10. Personal values9 2. 11. Life satisfaction9 2. 12. Health10 2. 3. Risk aversion10 3. CONCLUSIONS12 4. REFERENCES13 1. INTRODUCTION There are a lot of researches made to investigate the reasons why households participation in the stock market is relatively low. According to the numbers, only 21% of EU households participate in stockholding (European Survey of Consumer Finances, 2009). This looks irrational because the majority of the society members do not capture their chance to win additional benefits from their wealth in the stock market.The purpose of this exploratory research is to provide general insights about current status of households stock market participation and explain the variables that have effects on stockholding decision by households. Currently, the households investment level can be treated as market inefficiency due to irrational or unconscious households behavior. However, there is a number of external factors that influence the decision making in this field too.The statistics from variuos countries imply differences even among highly developed countries with similar GDP per capita like Italy with 14% and UK with 26% households stockholding level (European Survey of Consumer Finances, 2009). This means that there are externalities that lead to such differences and not just irrational households behavior determine the situation. To draw the full picture, this research focuses on both types of factors – internal and external. The following chapters include short analysis of the main factors that have impact on household st ockholding decision and the summary. . FACTORS THAT DETERMINE STOCKHOLDING DECISION OF HOUSEHOLDS 2. 1. Wealth Wealth refers to accumulated tangible and intangible assets. It is obvious that for stock investing households need to have some tangible assets to buy stocks. Therefore, wealth is one of the main factors that determine whether a household can actually invest, or in other words, convert savings to investment. According to the survey, 31% of respondents in EU state that they have some savings but do not participate in any kind of investing (European Survey of Consumer Finances, 2009).Households starting to invest face a number of costs such as time spent to understand the stock market system, get familiar with markets situation and trading flow. It may seem that the knowledge gain does not cost anything but there are opportunity costs when it comes to time. Other than that, there are also some direct tangible costs like transaction costs, taxes and other fees for the brokera ge. Of course for wealthier households this kind of barriers are less relevant, however, poorer households might be considering if possible benefits outweigh the costs. . 2. Intelligence quotient (IQ) and cognitive skills IQ is probably the most common measure to assess human intelligence. There is no doubt that beneficial stockholding requires appropriate level of intelligence to make good investing decisions. According to recent researches, there is a correlation between IQ and participation in stock market (IQ and Stock Market Participation, 2011). Households’ heads with higher IQ tend to diversify, hold mutual funds, more stocks and eventually bear lower risks with higher returns.In addition to IQ, it is worth to mention cognitive skills that have impact on participation and successfullness of stockholding. Good cognitive skills lead to lower time costs for getting knowledge and higher awareness that are so crucial for investing. 2. 3. Education In general, education prov ides a lot of advantages for societies and its members. Self development is crucial to gain cognitive skills, general knowledge, increase awareness and gain variuos experiences. These are the traits necessary for successful participation in stock markets.It is proven that education has positive correlation with households stockholding participation. More specifically, even one additional year of schooling increases the possibility of participation by 7% – 8% (Stock market participation and household characteristics in Europe, 2010). Moreover, decisions making of educated households’ heads are more rational. 2. 4. Country As it is mentioned in the introduction, different countries have created different environments for stock markets and, therefore, this is one more factor that can influence households stockholding decision.More specifically, governments can influence investment climate by adjusting such variables as taxes, laws, infrastructure, education, general count ry’s stability and even more. The Figure 1 below represents country specific percentage of households having direct and indirect stockholdings between 2006 and 2007 (Stock market participation and household characteristics in Europe, 2010). Figure 1. Stock market participation and household characteristics in Europe, 2010. In order to improve the opportunities for households to participate in tock markets, while at the same time to make it easier to enter the above-mentioned markets to new entrants, and to improve the conditions of participation for existing participants, and finally – to ensure the stability of financial markets, government often takes appropriate actions, whose has a relatively high impact on the further development of stock markets. Government must ensure the macroeconomic stability of financial markets, while at the same time they must ensure the existence of an open economy.A theory of an open economy is very important on the development of stock markets, because only in this case people and companies can freely trade in goods and services with other people and businesses, so that has a major impact on the growth of financial markets. Another neccessary condition for the success of any stock market is its repayment of stock dividends culture – before making any type of investment it must be ensured that stockholders will be allowed to get their dividends at a pre-determined time and at a pre-determined amounts.Talking about ensuring the fair trading process, European Union in 2004 released the EU’s Markets in Financial Instruments Directive (MiFID) (this directive was implemented three years later, in 2007), in order to open the door to the creation of new trading platforms directly operated by intermediaries, and in 2008, nine major investment banks (BNP Paribas, Citi, Credit Suisse, Deutsche Bank, Goldman Sachs, Merrill Lynch, Morgan Stanley, Societe Generale and UBS) has launched new pan-European equities tr ading platform (based in London) called â€Å"Project Turquoise†.Has this directive had an impact on stock markets? Yes. The issuance of this directive led European Union to increase competition and consumer protection in investment services. In order to complete this section about relevant government efforts, we must conclude that the relevant government actions truly has a significant effect on the growth of stock (and bond) markets, promotes fair trade among all countries included in the process of buying / selling stocks, and eventually – influences country's economic level to ncrease. But are these actions sufficient enough in order to ensure the increase of the involvement of households in the stock markets in the future? 2. 5. Information availability and ease to trade Technologies and their development have huge impact on everyday households life. Although nowadays the majority of wealthy households have ability to use the Internet, two decades earlier this was different and households participation in stock market rate was different too.The research of impact of the Internet to stock market participation reveals that there are strong evidences that the Internet penetration contributed to increased amount of households participating in stock market (Stock Market Participation and the Internet, 2008). According to the same research, the usage of the Internet increases the possibility to have stocks by 7%. This is mostly because of ease of stock trading (online trading), lower transaction costs and lower information costs. 2. 6. Market trustTrust is important factor for household’s decision to invest in stock market. Financial markets involve much risk and uncertainty. To tell the truth, the majority of households whose invest in stocks don't fully understand how the capital markets actually function. There needs to be some faith and certainty in this process. If it is known that a certain person or a company is unreliable and untrus tworthy, you, simply, don’t want to have any kind of business and common interests with them. The same is with households.In deciding whether to buy stocks, investors takes into account the risk of being cheated, so those households, whose generally are more trusting, are also more likely to invest in the financial markets, and those who are less trusting are less likely to invest in the market. Collapses of financial markets and its key participants – individual companies’ (when fraud was initiated and tolerated by heads of major companies) not only lowers the distribution of expected payoffs, but at the same time reduces the confidence in the system, which generates these enefits. A great example – company â€Å"Enron†. â€Å"Enron† was one of the biggest U. S. energy companies, however, when it was revealed lots of obscure in accounting procedures (it can be considered as a fraud), performed in 1990 on both â€Å"Enron† and its par tner, accounting company â€Å"Arthur Andersen†, there was a bankruptcy initiated on â€Å"Enron† – it was the largest bankruptcy in U. S. history. Share price fell from $ 90 to a few cents, and since those shares was considered to be very reliable, this bankruptcy was considered as disaster in the financial world.Company’s shareholders lost nearly $11 billion. What do you think, what impact do these examples of companies’ breakdowns have on the growth in confidence in financial markets? 2. 7. Age Another interesting fact in observing limited household stock market participation phenomenon – age. One of the factors that influence household’s decisions about stockholdings is the age’s effect on risk tolerance. There was a research done, in order to identify the risk tolerance level within specified age groups, and it showed that the risk tolerance decreases within the age.According to a research done by Rui Yao, Michael S. Gutte r, and Sherman D. Hanna, where they analyzed the effect of race and ethnicity on subjective financial risk tolerance, measuring age as a continuous variable, found out that each year increase in age decreased a probability of taking any type of risk by almost 2 %. Another factor, having significant impact on household investment decisions according to its age, is income.As this factor was discussed at one of the beginning pages of this research paper, it is worth to remind that different age groups receives different amounts of wages, what has an impact on their ability to act and to invest in financial markets. Finally, it is an interesting fact that interpersonal trust (trust is our previously described factor due to limited household participation in stock market, but this time this factor is viewed from a slightly different perspective) is more important for stock market participation decision within younger age groups and political orientation within older age groups. . 8. Mari tal status It’s not a secret that marital status is another important factor, which has a significant impact on household’s decisions whether to participate in the stock market or not. Married people are more willing to take (and share with each other) a certain level of risk than those, whose are living alone, and those, whose are living together, but are not married at all. There was a research done in order to identify the effects of marriage and divorce on financial investments.According to this research, women are more likely to invest in the stock market after their marriage, and take back their investment after divorce, while at the same time men shows quite different patterns on investment decisions. This suggests that the female gender is more risk averse than men (risk averse is also identified as one of the factors that has an impact on household’s investment decisions in the stock market), but in terms of couples who are married, a degree of risk mor e or less evenly distributes among themselves.It is worth to mention that marriage increases the likelihood of future investments in the financial markets for both men and women. There are lots of household finance literature available both online and in libraries, where it is often highlighted the differences in men and women behaviors while investing (marital status, as one of the factors having impact on households decision whether to participate in stock market or not, can be analyzed in a little bit different way.That’s true – by gender and by risk level each gender has possibility to take on themselves). According to the literature, the differences on investment preferences between men and women are more exposed, when individuals rather than married couples are being analyzed, because as it was mentioned earlier, married investors takes more risk than single investors. A distribution in risk by gender, talking in terms of marital status, is not the only reason fo r limited household participation in stock market. There an be distinguished several different factors, attributable to marital status – it‘s changes in household risk preferences, changes in background risks, and, also, changes in economic resources. 2. 9. Sociability (social interaction) Is it not true that working with a good company of friends involves more fun and at the same time the overall productivity increases? At the same time, don‘t you feel safer when you purchase a good, that was tested by people living in your environment, and it was recommended as a reliable and useful good?Another example would be a participation in any social program, where there previously participated, for example, your neighbours or friends – your decision-making process is very strongly influenced by the people of your environment, and here takes place the so-called phenomenon of word-of-mouth communication. All these examples perfectly suites to define one more factor , which explains limited household participation in stock market phenomenon – it is sociability, or, in other words, household‘s social interaction.Harvard Business School provides us with an opportunity to observe their findings about sociability‘s impact on stockholding decisions. Firstly, according to a research done, social households – those households, that has friendly and warm relations with their neighbours, are more likely to participate in stock markets, than those, whose relations with their neighbours are ruined or there aren‘t any neighbours in their environment. Secondly, as the proof of the first claim about sociability, researchers indicates that the impact of sociability is much more higher in those states with higher stock market participation rates.Quite „unexpectedâ€Å", right? Finally, they found out that differential between social and non-social households appears to have widened since 1990s. We often encounter with wor d-of-mouth communication‘s impact in our everyday‘s life, but when you are trying to assess sociability‘s influence on household decisions whether to participate on stock markets or not, you then realize the true power of a word. Word-of-mouth information sharing is key point in understanding sociability as another factor of limited household stockholding decisions, so we state that there‘s a significant impact of social interaction on such like household decisions. 2. 10. Personal values This research is gradually beginning to analyze not only the superficial factors, that affects household decisions related to stock market participation, but it also tries to look a little bit deeper into personal characteristics of an investor. One of the most important internal factor, having a great impact on investor‘s financial decisions, is personal values of an individual.A technical definition of personal values would be that it‘s the strongest internal p rovisions, having a large impact on our everyday decisions. Those everyday decisions are better know as our consumption decisions, they are also a major driver of our voting decisions and so on. Compared to other internal factors, such as risk aversion or life satisfaction (those are our next two internal factors, whose will be discussed a little bit later in this research), studies about personal values and its impact on our everyday‘s life are more preferable by today‘s researchers.According to their findings, personal values are connected to various demographic variables, i. e. Self-Transcedence and Openness to Change are the values that are proven to become more important when the level of education gets higher. It have also been proven that personal values are associated with social involvement, where, according to researchers, social involvement increases with the level of education. Finally, about two thirds of all studies shows that political orientation has stro ngest association with personal values.As every person has different values, the same is with political orientation – as there are many factors affecting citizens‘ lives, such as the income inequality, national security and so on, it is natural, however, that different values are emphasized in different environments. So what’s a true effect of personal values on investment decisions? Firstly, people with self-enhancement values of power and achievement are more likely to invest in stock markets than the others.And secondly, it is observed that personal values have a significant impact on those groups of people and their decisions, where investing in stock markets is relatively rare. 2. 11. Life satisfaction Isn’t it true that happier, more optimistic and satisfied with their life people embraces better decisions? What are the differences between pessimistic and optimistic people? – Optimists are more likely to believe that future economic conditions will improve. On the other hand, it is observed that optimistic people are working longer hours, they are more likely to remarry after divorce.So, optimism and life satisfaction are other important factors influencing households’ economy-related decisions. There was a research by Cambridge university‘s researchers done, where they found that optimism is highly correlated with stock ownership. People with higher levels of life satisfaction lives longer. Mostly. Therefore they think they are further from retirement, hence they are trying to control financial factors that are known that could affect their lifespan.It‘s a fact, that people, whose are more satisfied with their life, are working more, they are less pre-disposed towards retirement. What is more, it is more likely that one day they‘ll create any kind of business, so they‘ll become self-employed. Finally, optimistic people are more likely to remarry after divorce. All of this suggests that lif e satisfaction and optimism truly is a critical component of economic-decision making, and that those two factors plays an important role both on household decisions related to stock market participation and economic welfare of stockholders. . 12. Health Health risk is increasingly viewed as an important form of background risk that affects household portfolio decisions. According to household‘s level of health (whether it‘s poor or good) there‘s a possibility to detect whether household is willing to participate on the stock market or not – poor health is associated with smaller amount of risky assets and greater amount of safe assets. Researchers are trying to evaluate the links between health, health risk and portfolio selection.Recently it was observed that it does not matter whether households are trying to control their level of income and variety of socio-demographic characteristics, poor health decreases the probability of owning risky assets  œ for example, those households with poor health entails a higher risk of unexpected out-of-pocket medical expenditures, and prefers to own a corporate or government bond instead of holding a stock. Despite the fact that health risk quite often leads to a previously mentioned higher out-of-pocket medical expenditure risk, two possible outcomes can arise from such things.In particular, households may start changing the allocation of their financial resources, that can reduce their exposure to financial risk. On the second case, households can increase their precautionary saving, what reduces their ability to act in stock markets. At this point it is worth to mention that the intervention of government organizations reduces the impact of health risks related to household‘s stockholding decisions. That‘s why – it is observed that countries without adequate health care laws tends not to invest in risky financial assets, so this suggests an important role of such laws in shaping household‘s portfolio decisions. . 13. Risk aversion Finally, last but not least – factor, which had a significant role on this entire research. That’s risk aversion. We’ve emphasized different levels of risks on our study and their impact on household stockholding decisions, such as health risk or the age effect on risk tolerance. It has became clear that risk aversion reduces the probability of household‘s investments on risky assets. As the standard portfolio theory states, the amount of wealth a person wishes o invest in risky assets, depends directly on his degree of risk aversion, so it is logical to assume that if a person is more risk averse, he will hold safer portfolios. There was a research done several years in a row (from 1998 to 2001), where researchers found out that risk aversion has an effect not only on the structure of portfolio, but it also has an impact on the final decision whether an individual wants to become a stoc kholder (you should remember that previously we had a little discussion about that entry costs affects individuals‘ stock market participation decisions, too).Finally, talking about risk aversion‘s relation to other factors affecting stockholding decisions, it is found that risk aversion is negatively correlated with wealth. That‘s true – risk aversion decreases when wealth levels increases, and vice versa. To complete our discussion, another interesting fact – it was identified, that women are more risk averse than men, however, differences between genders, tends to be larger in single households (remember what effect on household‘s decisions on stockholding has marital status). 3. CONCLUSIONSIn general, all present researches about the topic agree that household stock market participation currently is not at the efficient point. There are a lot of complex factors that have impact on household stockholding decision and those have been discussed . However, some researchers observe even more correlations with stockholding decision and such interesting variables as race or living place but due to the limited scope of this exploratory research, these interesting factors are not taken into consideration. Needless to say, there are plenty of not mentioned factors that determine the level of stockholding.Of course, the governments are motivated to encourage investment level of households to make stock markets more efficient. There are some great examples how particular countries managed to increase the level of household stockholding over time. However, the complexity of the factors that lead to higher efficiency in each country are hard to determine and need further analysis to determine what works for each country particularly. Unfortunately, not all factors can be stabilized by the government. The global financial crisis of 2007-2008 showed that trust crisis in stock markets can not be handled so easily.Therefore, the only way to ensure sustainable stockholding growth is to adjust the system itself and add measures that could protect stockholders and decrease the possibility of such recessions. 4. REFERENCES 1. James P. Dow, Jr. , â€Å"Age, investing horizon and asset allocation†, 2008 2. George Korniotis, â€Å"Does Investment Skill Decline due to Cognitive Aging or Improve with Experience? †, 2007 3. Sule Alan, â€Å"Entry Costs and Stock Market Participation Over the Life Cycle†, 2006 4. 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