Earthquakes Hit the Stockmarkets - Even When They Don't Strike
In a disaster-prone world rational households' enthusiasm for holding stocks fades, Daniela Kolusheva, assistant professor at the Department of Finance assesses in her working paper Life-Cycle Portfolio Allocation When Disasters Are Possible, even if more conservative investments translate into an average loss of wealth (21% per year) and consumption (13.8%).
Since the late '60s, widespread life-cycle models dictate that households should hold almost all their financial portfolio in stocks, independently of their wealth or age. In the real world, though, "the majority of US households do not hold any wealth in the stock market and even among stockholders the average share of stocks out of financial assets was only about 51% in 2004 and 53% in 2007". Kolusheva's paper suggests that this could be due not to financial illiteracy, markets' malfunctioning or lack or trust in the regulators, but to the fear of rare but devastating events which may lead to market crashes and macroeconomic crises, sometimes simultaneously. Since earthquakes strike and wars occur, in other words, people shy away from stockmarkets.
Using long-term data since 1870 for the United States, Kolusheva estimates a mean equity premium of 6%, sufficient to explain the prevalent holding of stocks in the traditional models. In these models, though, labour income serves as a risk-free asset and households feel free to invest all their wealth in risky but high-yield activities like stocks. In Kolusheva's model, on the contrary, labour income is subject to the risk of macroeconomic crises and such risk affects the allocation of investments between risk-free bonds and stocks: the higher the perceived risk of macroeconomic crisis, the higher the allocation of wealth in risk-free, buffer-like bonds. Furthermore, stock markets are subject to the risk of crashes and the higher the perceived risk of crashes, the lesser the share of wealth households are willing to invest in stocks. In the worst cases macroeconomic crises and market crashes occur at the same time and the perceived likelihood of joint disasters keeps households even more away from investing in stocks.
Kolusheva uses Barro and Ursua (2009) taxonomy of disasters and defines market crashes as "peak-to-through cumulative real returns of -25% or worse" and macroeconomic crises as "cumulative declines in GDP or consumption of 10% or more", and using data on 30 countries since at least the '30s to 2006 identifies 232 stock market crashes and 100 depressions, with 71 cases of joint occurrence – before black swans and perfect storms were even heard of. It means that any investor faces a 2.64% probability of transition from a normal state in one year to a disaster that features both a market crash and a depression in the following year; a 7.47% probability of transition to a simple market crash and a 1.15% probability of transition to a simple macroeconomic crisis. The average stock return in case of joint disasters is -53% with a duration of 3.8 years, in case of simple market crash it's -43% in 2.9 years and in case of simple macroeconomic crisis it's -9% in 1.7 years. The average GDP contraction is respectively 23%, 1% and 17%.
When considering the riskiness of labour income and the likelihood of looming disasters, the behaviour of the rational agents changes and they hold less stock for any age and level of wealth.
Kolusheva tests her model, comparing it to the model without disasters, for realistic income parameters and a distribution of disasters matching the historic record and finds striking differences. The optimal share of stocks in investors' portfolio when in their 50s, for example, is 91% in the model without disasters and 29% when disasters are possible. In the latter model "the average middle-aged household allocates only 30% to 35% of its portfolio to risky assets, matching very closely the data for median stockholdings as a percentage of net worth from the 2007 Survey of Consumer Finances". The scholar reckons that the cost of being more conservative in investments in order to shun disasters is huge: a 21% loss in wealth and a 13.8% in consumption, due for the most part to the correlation between market crashes and macroeconomic crises.
It isn't the actual occurrence of disasters – Kolusheva underlines – to keep households at bay from stocks, but its perceived risk and small differences in the perception lead to huge differences in the share of stock, matching the diversity of the real world. A 6% perceived risk of disaster is sufficient to induce the median household to stay completely out of the stock market.