Limited Stock Market Participation Research Articles

Entry costs and stock market participation over the life cycle

Several explanations for the observed limited stock market participation have been offered in the literature. One of the most promising is the presence of market frictions mostly in the form of fixed entry and/or transaction costs. Empirical studies point to a significant structural (state) dependence in the stock market entry decision, which is consistent with costs of this type. However, the magnitude of these costs is not yet known. This paper focuses on fixed stock market entry costs. I set up a structural estimation procedure which involves solving and simulating a life cycle intertemporal portfolio choice model augmented with a fixed stock market entry cost. Important features of household portfolio data (from the PSID) are matched to their simulated counterparts. Utilizing a Simulated Minimum Distance estimator, I estimate the coefficient of relative risk aversion, the discount factor and the stock market entry cost. Given the equity premium and the calibrated income process, I estimate a one-time entry cost of approximately two percent of the permanent component of the annual labor income. My estimated model matches the zero median holding as well as the hump-shaped age–participation profile observed in the data.

Does Aggregate Relative Risk Aversion Change Countercyclically over Time? Evidence from the Stock Market

Using a semiparametric estimation technique, we show that the risk-return tradeoff and the Sharpe ratio of the stock market increases monotonically with the consumption wealth ratio (CAY) across time. While early studies have commonly interpreted such a finding as evidence of the countercyclical variation in aggregate relative risk aversion (RRA), we argue that it mainly reflects changes in investment opportunities for two reasons. First, we fail to reject the null hypothesis of constant RRA after controlling for CAY as a proxy for the hedge against changes in the investment opportunity set. Second, by contrast with habit formation models but consistent with ICAPM, we find that loadings on the conditional stock market variance scaled by CAY are negatively priced in the cross-sectional regressions. For illustration, we replicate the countercyclical stock market risk-return tradeoff using simulated data from Guo's (2004) limited stock market participation model, in which RRA is constant and CAY is a proxy for shareholders' liquidity conditions.

Does Market Incompleteness Matter for Asset Prices?

In this paper we argue that market incompleteness resulting from limited stock market participation is important for understanding the behavior of asset prices. (JEL: E32, E44, G12)

Minimum Consumption Level, Limited Stock Market Participation, and Equity Premium

Due to the high volatility of equity return, consumers always invest certain part of their income into riskless bond to guarantee the minimum consumption level after retirement, then invest the rest into stock. This 'pecking-order' behavior of investors increases demand for bond, reduces demand for stock, thus increases the equity premium. Moreover, richer consumers can afford to invest a higher proportion of wealth in equity while the poorer consumers invest a lower proportion of wealth in equity, consistent with the limited stock market participation observed empirically. The implications related to privatization of Social Security fund and the future trend of equity premium are also discussed.

Limited Stock Market Participation and Asset Prices in a Dynamic Economy

Limited Stock Market Participation and Asset Prices in a Dynamic Economy

Limited Stock Market Participation and Asset Prices in a Dynamic Economy

AbstractThis paper presents a consumption-based model that explains the equity premium puzzle through two channels. First, because of borrowing constraints, the shareholder cannot completely diversify his income risk and requires a sizable risk premium on stocks. Second, because of limited stock market participation, the precautionary saving demand lowers the risk-free rate but not stock return and generates a substantial liquidity premium. This model also replicates many other salient features of the data, including the first two moments of the risk-free rate, excess stock volatility, stock return predictability, and the unstable relation between stock volatility and the dividend yield.

Limited stock market participation and the equity premium

In this paper I study the implications of limited stock market participation for the equity premium. Earlier research suggested that limited stock market participation may potentially explain the high equity premium. This paper argues to the contrary and shows how the size of the equity premium in a limited participation economy depends on the assumptions about the structure of nonfinancial endowments. I calibrate a model of an exchange economy where all agents receive labor income and some agents are restricted from participating in the equity market. The key feature of the model is that, consistent with the data for the USA, stockholders derive a substantial fraction of their endowment from labor income. Due to limited risk sharing, the equity premium in such an economy is higher, but only slightly higher, than in an otherwise similar economy with full participation. I conclude that limited stock market participation does not play a significant role in explaining the equity premium puzzle.

Limited Stock Market Participation and Asset Prices in a Dynamic Economy

We present a consumption-based heterogeneous agent model that explains the equity premium puzzle and many associated asset pricing phenomena. The success of the model relies on a combination of limited stock market participation with uninsurable income risk and borrowing constraints. The two latter frictions - as shown by the early authors - generate a precautionary saving demand for tradable assets such as one-period discount bonds, and thus lower the risk-free rate. However, there is no precautionary saving demand for stocks because of limited stock market participation; therefore, our model generates a sizeable equity premium. Also, in the presence of borrowing constraints, the shareholder's consumption growth or the pricing kernel of stocks mirrors his income growth, which is volatile and mean-reverting. Stock prices, therefore, exhibit excess volatility as well as predictability. Moreover, the model predicts that stock market volatility is a U-shaped function of the price-dividend ratio, which helps explain the 'perverse' negative risk-return tradeoff documented in the literature. The argument for a leverage effect is thus not always valid; stock return is negatively related to contemporaneous conditional volatility mainly because of a volatility feedback effect.

On the Out-of-Sample Predictability of Stock Market Returns

Some recent research shows that macro variables, despite their enormous in-sample predictive ability, do not forecast stock returns out of sample. Specifically, Brennan and Xia (2002) cast doubt on the forecasting power of the consumption-wealth ratio (cay) because it is negligible in out-of-sample tests. In this paper, we argue that Brennan and Xia's results reflect an unstable relation between cay and stock returns. After we add lagged stock market variance, which follows from a limited stock market participation model by Guo (2000), and the stochastically detrended risk-free rate to the forecasting equation to partially control for the aforementioned unstable relation, the predictive power of cay improves dramatically. Also, simple trading strategies based on documented predictability tend to generate higher mean returns with lower volatility than the buy-and-hold strategy, and this difference appears to be economically important.

Limited Stock Market Participation and the Equity Premium

In this paper I study the implications of limited stock market participation for the equity premium. If all agents are receiving labor income and there is a small fixed cost of trading equities, then those agents with relatively low labor income choose not to participate in equity market. Because of limited risk sharing, the equity premium is higher, but only slightly higher, than in a model without frictions and full equity market participation. Thus, limited stock market participation does not resolve the equity premium puzzle.

A Simple Model of Limited Stock Market Participation

Stocks have outperformed government bonds, on average, by a large margin in historical data. However, most U.S. households do not own stocks, either directly or indirectly. Also, stocks are highly concentrated in the hands of relatively few wealthy people. In this article, Hui Guo describes some aspects of stock ownership. He then uses an overlapping-generations model to help explain why stock market participation is so limited and discusses some implications of limited stock market participation.