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.
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.
Guiso, Luigi, Paola Sapienza, and Luigi Zingales. 2008. Trusting the Stock Market. Journal of Finance, 63(6): 2557-2600.
-
3 Tips for Reinventing Your Career After a LayoffIt’s crucial to reassess what you want to be doing instead of jumping at the first opportunity.
-
College Campuses Are Becoming More Diverse. But How Much Do Students from Different Backgrounds Actually Interact?Increasing diversity has been a key goal, “but far less attention is paid to what happens after we get people in the door.”
-
When Do Open Borders Make Economic Sense?A new study provides a window into the logic behind various immigration policies.
-
Which Form of Government Is Best?Democracies may not outlast dictatorships, but they adapt better.
-
Podcast: Does Your Life Reflect What You Value?On this episode of The Insightful Leader, a former CEO explains how to organize your life around what really matters—instead of trying to do it all.
-
5 Ways to Improve Diversity Training, According to a New StudyAll too often, these programs are ineffective and short-lived. But they don’t have to be.
-
How Has Marketing Changed over the Past Half-Century?Phil Kotler’s groundbreaking textbook came out 55 years ago. Sixteen editions later, he and coauthor Alexander Chernev discuss how big data, social media, and purpose-driven branding are moving the field forward.
-
Your Team Doesn’t Need You to Be the HeroToo many leaders instinctively try to fix a crisis themselves. A U.S. Army colonel explains how to curb this tendency in yourself and allow your teams to flourish.
-
Immigrants to the U.S. Create More Jobs than They TakeA new study finds that immigrants are far more likely to found companies—both large and small—than native-born Americans.
-
Podcast: China’s Economy Is in Flux. Here’s What American Businesses Need to Know.On this episode of The Insightful Leader: the end of “Zero Covid,” escalating geopolitical tensions, and China’s potentially irreplaceable role in the global supply chain.
-
What Went Wrong at AIG?Unpacking the insurance giant's collapse during the 2008 financial crisis.
-
What Happens to Worker Productivity after a Minimum Wage Increase?A pay raise boosts productivity for some—but the impact on the bottom line is more complicated.
-
How Are Black–White Biracial People Perceived in Terms of Race?Understanding the answer—and why black and white Americans may percieve biracial people differently—is increasingly important in a multiracial society.
-
Why Well-Meaning NGOs Sometimes Do More Harm than GoodStudies of aid groups in Ghana and Uganda show why it’s so important to coordinate with local governments and institutions.
-
How Much Do Campaign Ads Matter?Tone is key, according to new research, which found that a change in TV ad strategy could have altered the results of the 2000 presidential election.
-
How Experts Make Complex DecisionsBy studying 200 million chess moves, researchers shed light on what gives players an advantage—and what trips them up.
-
Jeff Ubben Explains His “Anti-ESG ESG” Investment StrategyIn a recent conversation with Kellogg’s Robert Korajczyk, the hedge-fund leader breaks down his unique approach to mission-driven investing.
-
Why Do Some People Succeed after Failing, While Others Continue to Flounder?A new study dispels some of the mystery behind success after failure.