It Takes Trust to Invest
Trusting the stock market
Posted December 24, 2008
Trust is important for people to invest in stocks. This posting illustrates the general relationship between trust and participation in the stock market.
The stock market involves much risk and uncertainty. Let's face it, the majority of people who invest in stocks (directly, through funds, or in a retirement plan) don't fully understand how the capital markets actually function. Thus, there needs to be some faith in the process. If you think there is a high chance of being cheated, like the three-card Monte games played on the street, you simply don't play. People who are generally more trusting are also more likely to invest in the market. Those people who are less trusting are less likely to invest in the market. Without trust, people won't invest in the stock market. This impacts participation in retirement programs at work and owning mutual funds, as well as direct ownership of stocks.
Three financial economists (Luigi Guiso, Paola Sapienza, and Luigi Zingales) studied the relationship between a lack of trust and limited participation in the stock market in 12 countries. Citizens of these countries were asked, "Generally speaking, would you say that most people can be trusted or that you have to be very careful in dealing with people?" The higher the portion of a country answering that people can be trusted indicates a more trusting culture. This is graphed with the stock market participation rate of wealthy people (top 25% in wealth):
Note that countries with higher general levels of trust also have more people investing in the stock market. These researchers found that trusting others increases the probability of buying stock by 50% of the average. Trust is important for the market!
There are two aspects to having trust in the stock market. The first is the characeristics of the stock market. Are the people, institutions, processes, and history of the stock market worthy of trust? The second is how trusting are you? Go here for a discussion on the market's trustworthiness. Go here for a discussion on your capacity to trust the market.
Guiso, Luigi, Paola Sapienza, and Luigi Zingales, 2008, "Trusting the Stock Market," Journal of Finance 63(6), 2557-2600.