Paola Sapienza’s paper explores the relationship between trust and stock-market participation
1/8/2010 - Kellogg Finance Professor Paola Sapienza’s research on the link between trust and the stock market has earned her a prestigious Smith Breeden Prize.
Sapienza’s paper, “Trusting the Stock Market,” received a Smith Breeden Distinguished Paper Award on Jan. 4 at the American Finance Association’s annual meeting in Atlanta.
The prizes are awarded 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.
“Trusting the Stock Market” was co-authored by Luigi Guiso of the European University Institute and Luigi Zingales of the University of Chicago.
Financial literature has thus far ignored the role of trust in explaining stock market participation and portfolio choices, which inspired the professors to develop a model to measure this phenomenon, Sapienza said.
Those 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 said.
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 Enron, Bernard Madoff and Parmalat. Sapienza pointed 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 uncovered that differences in educational background rooted in past history or in 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 said.
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 said. “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 — which has been cited by many national and international media outlets, including The Financial Times, BusinessWeek and National Public Radio — is a quarterly measure of the confidence Americans have in financial institutions.
A member of the Kellogg faculty since 1998, Sapienza also serves as a faculty fellow for the Zell Center for Risk Research, as a research affiliate at the Center for Economic Policy Research, and as a faculty research fellow in the National Bureau of Economic Research’s program in corporate finance and political economy.
Her expertise covers banking and financial institutions, behavioral economics, behavioral finance, corporate finance, emerging markets and regulation of financial markets. She received her Ph.D. in economics from Harvard University in 1998.
Other Kellogg professors who have received the Smith Breeden Prize include:
Arvind Krishnamurthy, the Harold Stuart Professor of Finance;
Andrea Eisfeldt, associate professor of finance;
Mitchell Petersen, the Glen Vasel Professor of Finance;
Robert McDonald, the Erwin P. Nemmers Professor of Finance;
Artur Raviv, the Alan E. Peterson Professor of Finance;
and Michael Fishman, the Norman Strunk Professor of Financial Institutions.
Former Kellogg School professors Todd Pulvino and Kent Daniel are two-time recipients of the award.