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CHAPTER • Uncertainty and Consumer Behavior 183 a point where the expected return on the portfolio exceeds the expected return on the stock market In order to hold this portfolio, the investor must borrow money because she wants to invest more than 100 percent of her wealth in the stock market Buying stocks on margin in this way is a form of leverage: the investor increases her expected return above that for the overall stock market, but at the cost of increased risk In Chapters and 4, we simplified the problem of consumer choice by assuming that the consumer had only two goods from which to choose— food and clothing In the same spirit, we have simplified the investor ’s choice by limiting it to Treasury bills and stocks The basic principles, however, would be the same if we had more assets (e.g., corporate bonds, land, and different types of stocks) Every investor faces a trade-off between risk and return.16 The degree of extra risk that each is willing to bear in order to earn a higher expected return depends on how risk averse he or she is Less risk-averse investors tend to include a larger fraction of risky assets in their portfolios EX AMPLE INVESTING IN THE STOCK MARKET The 1990s witnessed a shift in the investing behavior of Americans First, many people started investing in the stock market for the first time In 1989, about 32 percent of families in the United States had part of their wealth invested in the stock market, either directly (by owning individual stocks) or indirectly (through mutual funds or pension plans invested in stocks) By 1998, that fraction had risen to 49 percent In addition, the share of wealth invested in stocks increased from about 26 percent to about 54 percent during the same period.17 Much of this shift is attributable to younger investors For those under the age of 35, participation in the stock market increased from about 22 percent in 1989 to about 41 percent in 1998 In most respects, household investing behavior has stabilized after the 1990s shift The percent of families with investments in the stock market was 51.1% in 2007 However, older Americans have become much more active By 2007, 40 percent of people over age 75 held stocks, up from 29 percent in 1998 Why have more people started investing in the stock market? One reason is the advent of online trading, which has made investing much easier Another reason may be the considerable increase in stock prices that occurred during the late 1990s, driven in part by the so-called “dot com euphoria.” These increases may have convinced some investors that prices could only continue to rise in the future As one analyst put it, “The market’s relentless seven-year climb, the popularity of mutual funds, the shift by employers to self-directed retirement plans, and the avalanche of do-it-yourself investment publications all have combined to create a nation of financial know-it-alls.”18 Figure 5.9 shows the dividend yield and price/ earnings (P/E) ratio for the S&P 500 (an index of stocks of 500 large corporations) over the period 16 As mentioned earlier, what matters is nondiversifiable risk, because investors can eliminate diversifiable risk by holding many different stocks (e.g., via mutual funds) We discuss diversifiable versus nondiversifiable risk in Chapter 15 17 Data are from the Federal Reserve Bulletin, January 2000, and the Survey of Consumer Finances, 2011 18 “We’re All Bulls Here: Strong Market Makes Everybody an Expert,” Wall Street Journal, September 12, 1997
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