Trusting the Stock Market

THE JOURNAL OF FINANCE • VOL. LXIII, NO. 6 • DECEMBER 2008 Trusting the Stock Market LUIGI GUISO, PAOLA SAPIENZA, and LUIGI ZINGALES ∗ ABSTRACT We study the effect that a general lack of trust can have on stock market participation. In deciding whether to buy stocks, investors factor in the risk of being cheated. The perception of this risk is a function of the objective characteristics of the stocks and the subjective characteristics of the investor. Less trusting individuals are less likely to buy stock and, conditional on buying stock, they will buy less. In Dutch and Italian micro data, as well as in cross-country data, we find evidence consistent with lack of trust being an important factor in

explaining the limited participation puzzle. 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. Episodes like the collapse of Enron may change not only the distribution of expected pay- offs, but also the fundamental trust in the system that delivers those payoffs. Most of us will not enter a three-card game played on the street, even after ob- serving a lot of rounds (and thus getting an estimate of the “true” distribution of payoffs). The reason is that we do not trust the fairness of the game (and the person playing it). In this paper, we claim that for many people, especially people unfamiliar with finance, the stock market is not intrinsically different from the three-card game. They need to have trust in the fairness of the game and in the reliability of the numbers to invest in it. We focus on trust to ex- plain differences in stock market participation across individuals and across countries. We define trust as the subjective probability individuals attribute to the pos- sibility of being cheated. This subjective probability is partly based on objective ∗ Luigi Guiso is from European University Institute and CEPR. Paola Sapienza is from North- western University, NBER, and CEPR. Luigi Zingales is from University of Chicago, NBER, and CEPR. We thank Raghu Suryanarayanan for truly excellent research assistance. Daniel Ferreira, Owen Lamont, ˇ LuboˇsP´astor, Annette Vissing-Jørgensen, an anonymous referee, as well as par- ticipants at seminars at the NBER Capital Markets and the Economy summer meeting, NBER Behavioral Finance November meeting, Bank of Italy conference “The Building Blocks of Effective Financial Systems,” Columbia University, Dutch National Bank, European Central Bank, Euro- pean Summer Symposium in Financial Markets, Harvard University, Imperial College, Institute for the Study of Labor, New York University, Northwestern University, Oxford University, Stanford University, MIT, Texas University at Austin, and University of Chicago have provided helpful com- ments. Luigi Guiso thanks Ministero dell’Universit'a e della Ricerca and the European Economic Community, Paola Sapienza the Center for International Economics and Development at North- western University and the Zell Center for Risk Research, and Luigi Zingales the Stigler Center at the University of Chicago for financial support. 2557 2558 The Journal of Finance characteristics of the...

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