Neighbors Matter: Causal Community Effects and Stock Market Participation

Abstract

This paper establishes a causal relation between an individual's decision whether to own stocks and average stock market participation of the individual's community. We instrument for the average ownership of an individual's community with lagged average ownership of the states in which one's nonnative neighbors were born. Combining this instrumental variables approach with controls for individual and community fixed effects, a broad set of time-varying individual and community controls, and state-year effects rules out alternative explanations. To further establish that word-of-mouth communication drives this causal effect, we show that the results are stronger in more sociable communities.STANDARD MODELS OF PORTFOLIO CHOICE typically assume that fully informed investors make rational asset allocation decisions to maximize lifetime utility. As Ellison and Fudenberg (1995 P. 93) note, however, "economic agents must often make decisions without knowing the costs and benefits of the possible choices" and thus often "rely on whatever information they have obtained via causal word-of-mouth communication." Given the evidence that average U. (2004) finds that nearly one-half of defined contribution plan participants report that they have little or no investment knowledge and fewer than 20% consider themselves relatively knowledgeable. Moreover, many respondents think that employer stock is less risky than a stock fund. 1510The Journal of Finance This paper empirically examines the inf luence of "community effects," in the form of word-of-mouth communication, on the decision about whether to participate in the stock market. In addition to its importance at the individual level, equity market participation is also important at the aggregate level because of its ability to inf luence the size of the equity premium (Mankiw and Zeldes (1991), Heaton and Lucas (2000), Brav, Constantinides, and Gezcy (2002)). It is also relevant for a variety of public policies, ranging from the incidence of dividend tax policy to whether investing Social Security surpluses in private investments can have real effects on the economy (Abel (2001), Diamond and Geanakoplos (2003)).Whereas standard models of portfolio choice indicate that most households should have equity market exposure, only one-third of U.S. households own stocks or stock mutual funds outside of retirement plans, and only one-half participate in the stock market even when retirement plans are included into the calculation.2 There are numerous reasons to suspect that one's decision about whether or not to invest in stocks may be inf luenced by the stock market participation of one's community by means of social interaction. Hong, Kubik, and Stein (2004) present a formal model and discuss several possible pathways for this effect. For example, social interaction may serve as a mechanism for information exchange by means of word-of-mouth communication or "observational learning" (Banerjee (1992), Bikhchandani, Hirshleifer, and Welch (1992), Fudenberg (1993, 1995)). Si...

Understanding Belgian Individual Investors: Complementarity of Qualitative and Quantitative Methodologies in a Grounded Theory Approach

“…11% of the investors precise that it's a family tradition what confirms the researches of Barnea et al (2010);  The influence of peers (Madrian & Shea, 2000;Duflo & Saez, 2002;Brown et al, 2008) is present both in the qualitative and quantitative steps when we discovered that professional and family environments are at the origin of the investment.  The illusion of control (Peteros & Aleyeff, 2013), or propensity that people have to identify success asd theirs and failure due to independent factors clearly appeared in our interviews and was confirmed via the survey (49 % of the investors invest alone, without intermediaries, in order to keep control on their investment).…”

Social Capital and Stock Market Participation via Technologies: The Role of Households’ Risk Attitude and Cognitive Ability

“…This conjecture is supported by several proposed explanations in the literature contemplating the role of participation costs in solving this puzzle [17,[20][21][22][23][24][25][26]. Moreover, scholars also reflected on behavioral approaches such as risk attitude [15,[27][28][29][30][31][32][33]; cognitive ability of households such as financial awareness [34], financial literacy [35], and IQ [36]; and sociological aspects including social interaction [5,8,12], trust [7,11] and shared vision [6,9,10,13]. This study reflects on the articles, considering risk attitude, cognitive ability, and sociological factors to explain the puzzle in stock market participation from the recommended journals in finance such as the Journal of Finance, Journal of Financial Economics, Review of Financial Studies, and Review of Finance.…”

“…This clarification leads to the issue of determining the set of financial products available to households. However, Brown et al [6] argued that households can still make serious investment mistakes even though many households find adequate solutions to the complex investment problems they face such as non-participation in risky asset markets, under-diversification of risky portfolios, and failure to exercise options to refinance mortgages.…”

“…Brown et al [52] made a seminal study about cognitive social capital and reflected on the investment behavior of members of the community to explain stock market participation. Another study used community participation to explain the phenomenon [6]. Kaustia and Knüpfer [9] analyze peer performance while the co-worker's investment decision is considered in the study of Hvide and Östberg [10] to explain stock market participation.…”

“…In effect, there is progress in exploring and explaining the rationality behind investor decision making through behavioral finance [4]. The previous studies on investment decision, particularly in stock market participation, have focused on solving the participation puzzle by linking social factors [5][6][7][8][9][10][11][12][13].…”