Trust is an essential part of any investment. After all, thousands of investors would not have handed their money over to Bernard Madoff if they had not felt they could trust him. But financial literature has thus far ignored the role of trust in explaining stock market participation and portfolio choices, an oversight that inspired Paola Sapienza (Professor of Finance at the Kellogg School of Management), Luigi Guiso (Professor of Economics at European University Institute), and Luigi Zingales (Professor of Finance at the University of Chicago) to develop a model to measure this phenomenon. “Trusting the Stock Market,” their paper that investigates the link between trust and the stock market, has earned them a prestigious Smith Breeden Distinguished Paper Award, a prize given annually to the top three papers published in The Journal of Finance on topics other than corporate finance. The winning papers are chosen by the journal’s associate editors.

People who lack trust in the market may view stock investments as they would a three-card game played on a street and decide to put their money elsewhere. “I think of trust as the subjective belief each one of us attributes to the possibility of being cheated,” Sapienza says.

This subjective belief is based partly on objective characteristics of the financial system—the quality of investor protection and the enforcement of laws, for example—that determine the likelihood of frauds such as those involving Madoff, Enron, and Parmalat. Sapienza points out, for example, that both trust and legal enforcement are weaker in Italy than in Sweden—and that people will trust less in a country where enforcement is tenuous. However, trust also reflects the subjective characteristics of that person who is trusting.

Trust is like the oil that lubricates the engine of financial transactions.

In previous research, Sapienza determined that differences in educational background rooted in past history or religious upbringing can create considerable differences in levels of trust across individuals, regions, and countries. “Trust is a very strong predictor of whether or not people decide to participate in the stock market and the fraction of their money they decide to put in the market,” Sapienza says. “Different degrees of trust among individuals and nations explain why some invest in stocks and others do not,” she adds.

“Culture is extremely important in shaping beliefs and preferences,” Sapienza notes. “In most economic transactions, people decide whether to participate depending on their expectation about how honest other people are. Trust is like the oil that lubricates the engine of financial transactions.”

As an outgrowth of their work on trust in the financial markets, Sapienza and Zingales in January 2009 developed The Chicago Booth/Kellogg School Financial Trust Index. The index is a quarterly measure of the confidence Americans have in financial institutions.

Further reading:
The Chicago Booth/Kellogg School Financial Trust Index

Measuring Trust, an Insight summary of the Financial Trust Index.