TAILIEUCHUNG - Trusting the Stock Market: LUIGI GUISO, PAOLA SAPIENZA, and LUIGI ZINGALES∗

Pro gres sively lower feed ef fi ciency raises the world price of ce real feed to the point where sub sti- tutes be come cost- effective. Pro duc tion shifts from re gions and com modi ties that can not un der take these sub sti tu tions at low enough cost to those that can. Coun tries such as Ar gen tina, with large pro duc tion ca pac ity on ranges, are fa vored in the “pes si mis tic” sce nario be cause they can com pete more eas ily, with more ex pen sive lot- fed beef, for ex am ple. The. | 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 riskreturn 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 payoffs 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 observing 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 explain differences in stock market participation across individuals and across countries. We define trust as the subjective probability individuals attribute to the possibility of being cheated. This subjective probability is partly based on objective Luigi Guiso is from European University Institute and CEPR. Paola

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