Trusting The Stock Market: an Impact on Stock Market Participation in Nepal

Introduction

A recent line of research found that trust plays an important role in financial decision-making. A great deal of confidence that the financial sector is fair is required for Investing in the stock market and financial products and services. The decision to invest in stocks requires not only an assessment of the risk–return trade-off given the existing data, but also an act of faith (trust) that the data in our possession are reliable and that the overall system is fair. This article attempts to dig deeper into the trust-based explanation of individuals’ financial decisions and explore the effects in stock market participation in particular.

Guiso, Sapienza and Zingales (2004, henceforth GSZ) have studied the effect of trusting behavior on portfolio choice decisions. They argue that an investor’s perception of the risk of an asset depends not only on the asset, but also on subjective characteristics of the investor. The reason is that the return may be affected by misbehavior of other parties. Moreover in GSZ (2008) they have examined the effects of trust on stock market participation.

GSZ also associate differences in stock market participation across countries with variation in aggregate levels of trust by regressing the share of stockholders in each country on the average levels of trust and few other country-wide indicators As a consequence, trust in others matters for the subjective expected return, and less trustful individuals hold fewer stocks. These authors find empirical support for this hypothesis using data from Italy and from the Netherlands. Georgarakos and Pasini (2011) add to this research by linking trust and sociability to the significant regional differences in stockholding in ten major European countries, and conclude that both factors should be taken into account when studying households’ stock-market participation decisions.

Durlauf and Fafchamps (2004), after reviewing various definitions of social capital and several related empirical studies, distinguished three common features: “

• Social capital generates positive externalities for members of a group;
• these externalities are achieved thanks to shared trust, norms and values and their effect on expectations and behavior;
• shared trust, norms and values arise from informal organizations based on social network and associations.”

Moreover Hong, Kubik and Stein (2004, henceforth HKS), in an influential paper, provide evidence that sociability, as proxied by relationships with neighbors and church visits, fosters stock market participation. From these literatures incorporating sociability poses high importance therefore it is included as a control variable. Optimism is also placed as a control variable because the outcomes of optimism deepen and expand trust.

According to Pennacchi (2008)’s standard financial theory, all individuals should invest a fraction of their wealth into risky assets. The reality, however, is not as ideal as the standard financial theory. Following the studies of Bertaut and Starr-McCluer (2002), it is found that many households have negligible financial assets. Even the median household has a slight fraction of financial assets. Empirical research states that fixed participation cost is the primary explanation for the participation puzzle. However other evidence such as report of Guiso and Sodini (2013) shows that even wealthy individual do not always invest in stocks. Other than fixed participation costs the demographic factors, such as income, age, and education are also important (Campbell, 2006).

This paper investigates behavioral finance and attempts to explain the participation rate in the stock market from trust perspective. Besides, the previously discovered determinants such as household wealth, income, age, gender and education are included in this study to describe wealth effect and demographic effect.

The key motivation of this study is to examine the contributions of trust on stockholding and evaluate the possible implications for observed differences in households’ investment behavior across various backgrounds. This main objective is followed by following specific objectives:

1. To examine the effect of trust on stock market participation in two direction; participation decision and participation level.
2. To analyze the most influencing trust category for stock market participation.

Literature Review

In 2006, John Campbell coined the name “Household Finance” for the field of financial economics that studies how households use financial instruments to achieve their objectives. Since then, household finance has attracted much academic interest. According to the framework by Campbell (2006), existing research has recently focused on three primary aspects of household finance such as participation puzzle (Haliassos & Bertaut, 1995), diversification problem (Graham, Harvey & Huang, 2009) and mortgage decisions (Campbell & Cocco, 2003).

Stock market participation puzzle, which was first introduced by Haliassos and Bertaut (1995), has attracted extensive interest in existing literature (e.g. GG Pennacchi, 2008; Bertaut & Starr-McCluer, 2002). In broad terms, stock market participation puzzle can be defined as the gap between what households are supposed to do according to theories and what they do in reality (Bertaut & Starr-McCluer, 2002).

In standard financial theory (GG Pennacchi, 2008), all individuals should at least hold a fraction of their wealth in risky assets regardless utility function and wealth base. The implication, however, fails to hold in reality. Household behaviors deviate from what normative models prescribe in most circumstances. Following the studies of Bertaut and Starr-McCluer (2002), Haliassos and Bertaut (1995), and Tracy, Schneider, and Chan (1999), it is almost certain that many households have negligible financial assets. Further, it has been reported that even the median household has a slight fraction of financial assets.

To explore the participation puzzle, research (e.g. Campbell, 2006) has developed in a variety of directions, and many determinants are identified during the past decade. Empirical research states that fixed participation cost is the primary determinants for the participation puzzle. For instance, Vissing-Jorgensen (2003) examined the impact of participation costs on stock market participation and concludes that rational participation decision can be dramatically different when adding participation costs. A broadly accepted interpretation is that fixed participation costs consume a bigger fraction of poor household’s wealth and thus motivate the household to stay outside of the stock market. Following this, total asset, as a measure of wealth is included in this study.

Even though the rate to participate is better for wealthy households compared to low-income households, the rate is still not high. For instance, 10% of the wealthiest households do not hold equity (US households in the 2007 wave of the SCF). This implies that wealth effect caused by fixed costs is not the only explanation for the low participation rate. The demographic factors, such as income, age and education may also be important.

Age has been studied for a long history as a determinant of the economic decision in a household. One of the famous theories is Modigliani's life cycle theory (Modigliani, 1966). According to this theory, people build up their stock of assets during their working life and use them after they retired. Thereby, it is reasonable to assume that this behavior is also reflected in stock market participation.

The participation rate also has clear differences between genders. For instance, Bajtelsmit & Bernasek (1996) have proven that male has a higher level of risk tolerance than female in general. The conclusion is confirmed by Dreber (2012), which examined the higher participates rate for men.

Further, education background is another determinant that cannot be ignored. In general, financial literacy has been identified as a factor that lowers the fixed participation costs. Higher levels of education and cognitive ability causes increased participation (Cole & Shastry, 2009).

Despite the research that focuses on wealth and demographic effect (Campbell, 2006), a new area has taken a different direction in trying to identify behavioral related determinants. Recent research in behavioral economics has already earned much attention from economists. In general, behavioral finance is an umbrella term for a range of approaches that seeks to understand and explains observed individual behavior more accurately than predictions associated with traditional finance theory. Given that wealth effect and demographic effect alone are not enough to explain the observed low market participation rates; more researchers try to explain the puzzle from behavioral finance.

Topics such as fame effect, mental accounting, trust and overconfidence have been studied intensively (Chuah & Devlin, 2010). In following sections, research on trust will be discussed.

According to Sapienza, Toldra-Simats, and Zingales (2013), trust is a subjective belief in others’ trustworthiness, i.e., the probability of being cheated by the counterpart in a financial transaction. However, trust is a multidisciplinary concept and there is a rich literature on trust in other fields, most notably in philosophy, sociology, and psychology. In psychology, in particular, trust is considered to be one of the primary human emotions (Plutchik, 1982) and a number of studies indicate that emotions exert a powerful influence over cognition and decision making (Barrett, 2009)

In stock market participation puzzle, the level of trust is identified as an important determinant. Guiso, Sapienza and Zingales (2008) examine a three-card game to analyze the participation of the stock market. Most people will not participate in the game with a reason of not trusting the fairness of the game. History has proven that the stock market is not a fair game all the time. As stated in the study of Giannetti and Wang (2014), corporate fraud disclosing leads to lower trust in the probability of participating in the stock market.

Many previous studies have proved that the strong effect of trust on stock market participation. By studying in Dutch and Italian micro data, Guiso, Sapienza, and Zingales (2008) prove that the lack of trust is an essential factor to explain the limited participation puzzle. They document a positive relationship between trust and stock investment. In addition, they also correlate the stockholders’ share in each country with the average level of trust and find that those countries with high prevailing trust have a higher stock ownership rates.

The results show that prospective investors who live in low-trust countries or do not trust in others are more sensitive about being cheated, which prevent them from holding stocks. Further, based on the study above, Asgharian, Liu and Lundtofte (2014) develop a framework to analyze the formation of trust and the impact of trust on stock market participation.

The main difference of their model is that they consider that trust is formed through learning. They explore the relationship between institutional quality, trust and stock market participation by using a large sample of European (SHARE survey) data that covered 30,000 individuals in 14 European countries. They show that the level of trust related to institutional quality has a strong impact on the probability of stock market participation.

Mårten Hagman (2015) proves the significance of trust in the decision of stock market participation by using the data containing over 60,000 individuals across 15 countries. In fact, they find that trust is a much better predictor of stock market participation rate than GDP per capita. High trust has a strongly positive correlation with stock market participation.

Moreover, Georgarkos and Pasini (2011) firstly test trust combined with sociability. They argue that both trust and sociability should be considered when studying the household’s decision of participating stock market; however, they also find that a reduction of trust can be offset by an increase of sociability.