Limited Capital Market Participation and Human Capital Risk

The non-tradability of human capital is often cited for the failure of traditional asset pricing theory to explain agents’ portfolio holdings. In this paper we argue that the opposite might be true — traditional models might not be able to explain agent portfolio holdings because they do not explicitly account for the fact that human capital does trade (in the form of labor contracts). We derive wages endogenously as part of a dynamic equilibrium in a production economy. Risk is shared in labor markets because firms write bilateral labor contracts that insure workers, allowing agents to achieve a Pareto optimal allocation even when the span of asset markets is restricted to just stocks and bonds. Capital markets facilitate this risk sharing because it is there that firms offload the labor market risk they assumed from workers. In effect, by investing in capital markets investors provide insurance to wage earners who then optimally choose not to participate in capital markets. The model can produce some of the most important stylized facts in asset pricing: (1) limited asset market participation, (2) the seemingly high equity risk premium, (3) the very large disparity in the volatility of consumption and the volatility of asset prices, and (4) the time dependent correlation between consumption growth and asset returns. A commonly held view amongst financial economists is that a significant fraction of wealth consists of non-tradable assets, most notably human capital wealth. Indeed, this hypothesis is often used to explain why one of the key predictions of the CAPM does not hold, that all agents hold the same portfolio of risky assets. Because investors should use the capital markets to diversify as much risk as possible, and because non-tradable human capital exposure varies across individuals, investors should optimally choose to hold different portfolios of risky assets. Although this explanation certainly has the potential to explain the cross sectional variation in portfolio holdings, it also necessarily implies wide stock market participation. However, the fact is that the majority of people do not participate in the capital markets. Not only do these individuals appear to eschew the opportunity to partially hedge their human capital exposure, the hedging of human capital risk does not appear to be a primary motivator for the minority of people who actually do participate in capital markets. Instead, the anecdotal evidence suggests that rather than a desire to hedge, what motivates most investors is a willingness take on additional risk because they find the risk return tradeoff attractive.1 The object of this paper is to put forward a plausible explanation for these two characteristics of investor behavior. The most commonly cited explanation for why most people do not participate in capital markets is barriers to entry, although in economies such as the United States it is difficult to accept that significant economic barriers to entry exist that prevent people from participating. Instead, most researchers cite educational barriers to entry because research has shown that education level is strongly correlated with participation.2 But the problem with this explanation for limited stock market participation is that it does not address the question of why the educational barriers exist at all. After all, we see wide participation in arguably more complicated financial products such as mortgages, auto leases and insurance. In these cases the educational barriers to entry were removed by the motivation to make profits — firms invested considerable resources in educating people so they could sell these products. Given the welfare gain to hedging non-tradable human capital, why does a similar economic motivation to educate consumers to hold stocks apparently not exist? Market incompleteness may potentially offer an explanation for limited stock market participation. For instance, the asset span might be so “narrow” that the stock market offers little opportunity for Pareto improving trades. Although rarely cited explicitly, this explanation is implicit in the literature on non-traded wealth. But, for this explanation to hold water, one must also then account for why the asset span does not endogenously expand. In fact, the span of traded assets has changed only marginally in recent years, despite the explosion in the For example, considerable resources are devoted to advising people on how to find high return investments whereas advice on investments with good hedging characteristics is largely non-existent. Mankiw and Zeldes (1991) document the relation between education and participation and Hong, Kubik, and Stein (2004) document that non-formal education, such as social interaction, is also correlated with participation. Malmendier and Nagel (2009) provide evidence that irrationality might also play a role — investors appear to misestimate the return to investing in capital markets because they put too much weight on their own experience.