Finance & Accounting Feb 1, 2010

Trust­ing the Stock Market

Impres­sions influ­ence investors decisions

Based on the research of

Luigi Guiso

Paola Sapienza

Luigi Zingales

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.

Featured Faculty

Paola Sapienza

Donald C. Clark/HSBC Chair in Consumer Finance, Professor of Finance, and Zell Center Faculty Fellow

About the Writer

Amy Trang is a publications writer at the Kellogg School of Management.

About the Research

Guiso, Luigi, Paola Sapienza, and Luigi Zingales. 2008. Trusting the Stock Market. Journal of Finance, 63(6): 2557-2600.

Read the original

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