TAILIEUCHUNG - TRUSTING THE STOCK MARKET

We define trust as the subjective probability individuals attribute to the possibility of being cheated. This subjective probability is partly based on objective characteristics of the financial system (the quality of investor protection, its enforcement, etc.) that determine the likelihood of frauds such as Enron and Parmalat. But trust reflects also the subjective characteristics of the person trusting. Differences in educational background rooted in past history (Guiso, Sapienza, and Zingales (GSZ), 2004a) or in religious upbringing (GSZ, 2003) can create considerable differences in levels of trust across individuals, regions, and countries. This difference between subjective and objective beliefs can persist because learning about the true probability of. | TRUSTING THE STOCK MARKET Luigi Guiso University of Sassari University of Chicago CEPR Paola Sapienza Northwestern University NBER CEPR Luigi Zingales Harvard University NBER CEPR September 19 2005 Abstract We provide a new explanation to the limited stock market participation puzzle. In deciding whether to buy stocks investors factor in the risk of being cheated. The perception of this risk is a function not only of the objective characteristics of the stock but also of the sub jective characteristics of the investor. Less trusting individuals are less likely to buy stock and conditional on buying stock they will buy less. The calibration of the model shows that this problem is sufficiently severe to account for the lack of participation of some of the richest investors in the United States as well as for differences in the rate of participation across countries. We also find evidence consistent with these propositions in Dutch and Italian micro data as well as in cross country data. JEL Classification D1 D8 Keywords Stock market participation trust portfolio choice We thank Raghu Suryanarayanan for truly excellent research assistance. Owen Lamont Annette Vissing-Jprgensen as well as participants at seminars at Columbia University the NBER Capital Markets and the Economy summer meeting New York University MIT Northwestern University University of Texas at Austin and the University of Chicago have provided helpful comments. Luigi Guiso thanks MURST and the EEC Paola Sapienza the Center for International Economics and Development at Northwestern University and Luigi Zingales the Stigler Center at the University of Chicago for financial support. 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 that the overall system is fair. Episodes like the collapse of Enron may change not only the distribution of expected payoffs but the

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