Column : Why dont we invest in equity

Written by Tarun Ramadorai | Updated: Mar 9 2011, 04:43am hrs
The entire Arab world is quaking at the moment as the aftershocks of Egypt and Tunisia percolate through the minds of those striving for democracy. The populations of these countries, among many other important political demands for reform, are calling for more jobs and housing. As a consequence, the rulers of many of the autocratic regimes in the region are now promising long-overdue concessions.

These concerns are primarily political but many have economic underpinnings. They are not restricted to the very poorest in society, although their concerns are, of course, pivotal. Members of the middle classes are also concerned about employment, housing, pensions and retirement. Concerns have also been expressed in the aftermath of the financial crisis about trust in financial institutions. Can they be trusted to preserve and create wealth for the ordinary public rather than merely enriching the elite The Arab world is an extreme example of the manifestation of concerns that are highly important for people in the bottom two-thirds of the income distribution globally.

Economics has moved towards thinking about these problems more broadly. What was once the purview of specialist economists studying narrowly-defined poverty reduction problems has moved into the mainstream. One way to come at these problems is to define them in terms of the largest financial choices that households make. For example, mortgage availability and choices, personal defaults and payday lending, retirement savings, equity market participation and mutual fund investment. These decisions are affected by two equally important questions. First, are financial institutions structured and regulated in such a manner as to encourage fiscally prudent and responsible choices by their clients This question is being actively pursued at the moment by global regulators and academics alike; presumably it will be at the top of the agenda for the new head of Sebi.

The second important line of inquiry is about whether households have sufficient financial education to correctly make choices that are optimal. Here, there are also important issues to grapple with. The evidence is that there is significant variation across individuals in their level of financial sophistication. As John Campbell described in his Presidential address to the American Finance Association in 2006, For a minority of households, particularly poorer and less educated households, there are larger discrepancies (between observed and ideal financial behaviour) with potentially serious consequences ... these discrepancies, or investment mistakes, are central to the field of household finance.

What investment mistakes are most common To answer these questions, detailed data on households investment decisions are important. Such data are available from countries such as Sweden, where there is a wealth tax and well-kept records that are made available to researchers. Using such data, academics have discovered that financial sophistication tends to be correlated with wealth, in the sense that wealthier households hold better performing portfolios. (Continuing with the theme that wealth and financial sophistication appear to go hand in hand, there is also evidence that wealthier households are quicker at refinancing their mortgages when it is optimal to do so.) Furthermore, poorer households tend not to participate in equity markets, even when they have the ability to do so. It is also the case that many households appear not to hold well-diversified portfolios, contrary to the standard precepts of finance theory. Ironically, this lack of diversification appears to eliminate some of the gain from participation in the stock market.

What can we take away from some of these results for policymaking in India It is clearly the case that better financial education is an important ingredient towards improving peoples economic lives, in addition to financial regulation and transfers. To go further with this important agenda, however, we need more research that is tailored towards the needs of emerging markets like our own. Thus far, most household finance research has concentrated on developed countries, mostly on account of better data availability. This gap can be rectified if we invest significant resources in collecting such data in our country (perhaps in combination with initiatives such as Aadhar), and make it available to interested researchers.

These questions are interesting intellectually as well as from a policy perspective. We are experiencing financial innovation at a much faster pace than developed countries, and it is critical to find out how our households are handling the new financial instruments that are becoming available. There are also significant questions about micro-finance and other investment products that have evolved to suit the circumstances of poorer households. The Malegam Committee report is a serious look at how best to regulate this sector, but research on this important area from the perspective of the customers is still ramping up. We should devote more resources towards answering these important questions.

The author is a financial economist at Sad Business School, University of Oxford