A Simple Model of Limited Stock Market Participation

The 1998 Survey of Consumer Finance data shows that only 48.8 percent of U.S. households owned stocks, either (i) directly or (ii) indirectly through mutual funds. In addition, there is a close relationship between shareholding and wealth. In 1998, 93 percent of the richest 1 percent of the population owned stocks; the richest 10 percent owned 85 percent of total stocks and mutual funds, compared with 51 percent of total savings deposits. Meanwhile, the average stock return is “abnormally” higher than the average government bond return.1 In this paper, I try to explain this shareholding puzzle—why many people do not hold stocks given that stocks outperform government bonds by a large margin. It is costly to collect and process information about stock markets. Bertaut (1997) finds that better-educated people are more likely to hold stocks, even after controlling for variables such as wealth, current income, and unemployment risk. He interprets education as a measure of the ability to process information about the market and investment opportunities. However, information costs are not the only reason for limited stock market participation. Rather, recent research emphasizes that people tend to hold fewer risky assets such as stocks in their portfolio if they are more vulnerable to income shocks. For example, borrowing constraints (Guiso, Jappelli, and Terlizzese, 1996), labor income risks (VissingJorgensen, 1998b), home ownership (Fratantoni, 1998), and entrepreneurial risks (Heaton and Lucas, 2000) are found to deter stock market entry. Moreover, these factors have smaller effects on people who have larger wealth. Holtz-Eakin, Joulfaian, and Rosen (1994) find that people are willing to take more risks if they receive a large inheritance. In this paper, I develop a life-cycle model to show how market imperfections may interact with heterogeneous wealth to generate limited stock market participation. Many factors, such as successful entrepreneurial effort, life-cycle savings, precautionary savings, and inheritance, explain wealth inequality. To keep the model manageable, I focus on three key elements, namely, different investment opportunities (stocks and bonds), credit market imperfections, and inheritance. In the model, although the stock return is higher than the bond return, only people with wealth over a certain threshold own stocks. This occurs for two reasons. First, there is a fixed cost to entering the stock market. Second, people face a borrowing rate that is higher than the saving rate so that they cannot arbitrage by selling bonds and buying stocks. As a result, wealthy households accumulate more wealth and pass on a greater inheritance to their families than poor households do. In the long run, wealth is unequally distributed and wealthy households own almost all stocks. Some other mechanisms have explained limited stock market participation. Becker (1980) shows that the most patient agent owns all capital in the long run. Allen and Gale (1994) argue that the less risk-averse person is more likely to hold stocks. Constantinides, Donaldson, and Mehra (2000) stress the life-cycle pattern of shareholdings. Asset returns and limited stock market participation are two closely related issues. However, recent research (i.e., Constantinides, Donaldson, and Mehra, 2000; Polkovnichenko, 2000; and Yaron and Zhang, 2000) has had difficulty explaining the two simultaneously in general equilibrium models. Therefore, I address asset returns and limited stock market participation separately in this paper. First, the asset return is accepted as given when I explain why there is limited stock market participation. Then limited stock market participation is accepted as given when I discuss its effect on the asset return. Nevertheless, we ultimately need to develop a general equilibrium framework that explains both simultaneously, but this is beyond the scope of this paper. Limited stock market participation may have large effects on asset prices. The risk of the stock market return is measured by its covariance with shareholders’ consumption growth in the standard framework, the consumption-based Capital Asset