Central Banker - Autumn 2001

Treasury Implements New TT&L Investment Option

New Look, Same Book

Fed Updates District Telephone Systems to Improve Customer Service

Going Modern: Fed Brings Check-Processing Systems into the New Millennium

Reserve Board Creates New Form to Reduce Respondent Burden

Despite the Recent Boom, Stockholding Is Still in the Hands of Few

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Despite the Recent Boom, Stockholding Is Still
in the Hands of Few

Hui Guo, economist, Federal Reserve Bank of St. Louis

The 1990s were exceptionally good years for stock market investors. The Standard and Poor's 500 index, which measures the value of the largest 500 firms, increased eight years during the decade and climbed 15 percent per year on average. Many observers have noted that the '90s' stock market boom coincided with a surge in the number of households that owned stocks--either directly or indirectly--through mutual funds, retirement accounts and other managed assets. As the accompanying chart shows, the stock market participation rate rose sharply from 32 percent in 1989 to 49 percent in 1998. Did this large influx of new investors propel the decade's stock market boom? Economic theory suggests that if an increase in the number of shareholders spreads stock market risk over a larger pool of investors, then the rate of return required to compensate shareholders for their risks ought to fall. This would cause a one-time increase in stock prices.

It is tempting, then, to argue that the increase in stock market participation played a significant role in the recent boom.

(click on graphic to enlarge)

However, a closer examination of the data shows that most new shareholders own a relatively small amount of stocks.

The accompanying chart also reveals that the share of stocks held by the richest 10 percent of American households remained between 78 and 82 percent during the period between 1989-98. This means that aggregate stockholdings remain highly concentrated in the hands of the wealthiest 10 percent. Hence, the argument discussed above does not apply because even though the number of shareholders increased, a relatively small pool of wealthy investors still absorbed most of the risk.

Other explanations for the most-recent stock market boom include:
• The baby-boom generation entered its peak savings years, and boomers' large demand for stocks fueled prices.
• Productivity increased rapidly because of the information-technology revolution.
• Because of the quick growth of mutual funds, American households tended to hold a more-diversified portfolio than before the recent boom.
• Irrational exuberance could have driven the price of stocks above their fundamental values.

However, economists John Heaton and Deborah Lucas argue that none of these factors can explain a significant portion of the 1990s' stock market run-up. Because stock prices have been very volatile throughout its history, the recent boom might be a cyclical deviation from the trend.

It is puzzling that a large fraction of American households continue to own few or no stocks because, on average, stocks have outperformed government bonds by a large margin. In a recent issue of the Review, the Bank's economics journal, I discussed several possible explanations.

• First, collecting and processing stock information is costly, and the costs for researching investments may be prohibitive for small investors.
• Second, because volatile housing prices pose a considerable risk, and a home is the most-important asset held by the average household, this risk could lead average workers to invest conservatively.
• Third, stock market returns are volatile in the short run and tend to be negative during business-cycle downturns--just when the average worker faces an increased risk of being unemployed.

One can argue that because of the information-technology revolution, information costs have become less important for making investment decisions. The research clearly indicates that our economy's reliance on labor income and the average worker's home-ownership patterns are the primary reasons why stock ownership remains highly concentrated in the hands of a few wealthy households. Simply put, working people--who face considerable labor-income risk and have a limited ability to borrow--often choose to put their savings into relatively safe assets instead of stocks.

This article is adapted from his June 2001 National Economic Trends article, "Stockholding Is Still Highly Concentrated." For further reading see Heaton, John and Deborah Lucas, "Stock Prices and Fundamentals." NBER Macroeconomics Annual, 1999. Guo, Hui. "A Simple Model of Limited Stock Market Participation." Federal Reserve Bank of St. Louis Review, May/June 2001.