Financial Market Equilibrium When Stock Ownership Is A Consumption Good
Jiang Luo
Nanyang Technological University (NTU) – Division of Banking & Finance
Avanidhar Subrahmanyam
University of California, Los Angeles (UCLA) – Finance Area; Institute of Global Finance, UNSW Business School
March 25, 2016
Abstract:
We analyze a model where owning certain types of stock confers direct utility, in addition to impacting wealth. Phenomena such as misvaluation, a value effect, negative expected profits from trading, and volume premia arise naturally in this setting. In contrast to the more traditional wealth effects of financial assets, stock prices are unconditionally biased even when assets are in zero net supply. We predict that misvaluation in a stock will be more prevalent if a larger proportion of agents directly derive extreme utility or disutility from holding stock.
Financial Market Equilibrium When Stock Ownership Is A Consumption Good – Introduction
“I often owned 25 to 30 stocks at one time, all in small parcels…For some of them I acquired a special liking…I thought of them as something belonging to me, like members of my family…” — Darvas (2011)
One of the more interesting and puzzling stylized facts in finance is the notion that some financial market agents lose money on average; see, for example, Barber and Odean (2001) or Odean (1999). This finding contradicts virtually every financial model, and it could be argued, basic common sense. Why would agents trade equities if the expected return from doing so is negative? Of course, the most logical explanation is that they do not trade to earn negative average returns, but trade under the assumption that they truly have valid information about equities when they do not. However, in a repeated setting, this seems implausible. A holder of a discount brokerage account should learn quickly from experience that their information set is fairly poor, and trade less. But, as Barber and Odean (2000) point out, it seems that the agents who trade the most actually perform the worst, so that the potential learning from investing via trading does not appear to improve trading performance. Why?
We argue that the above outcome is possible if agents receive direct utility from owning stock. For example, an agent who owns stock in Apple might feel that they in fact are rewarding the company for slick and useful products, without regard to the actual cash flows Apple is expected to yield. Similarly, an agent who cares about the environment might buy shares in Tesla Motors, again without regard to cash flows. This type of behavior is plausible, and plenty of references in the popular press are testament to the notion that investors often “fall in love” with stocks.1 Further, the arguments of Kahneman (1982) indicate that investors might make investment decisions based on heuristics, and one heuristic is simply how attractive the company’s products are, so that brand visibility is one potential source of attachment to a company’s stock.2 Nagy and Obenberger (1994) find in a survey of individual investors that a primary reason for stock investment is “feelings for firm’s products and services,” which is an emotional reason for attachment to a stock. Beal, Goyen, and Philips (2005) point to a possible increase in psychic well-being from owning socially responsible investments.3 In the phenomenon he terms “consumer ethnocentrism,” Shankarmahesh (2006) indicates that agents might prefer investments in domestic, rather than foreign, brands, for emotional reasons. Motivated by these observations, in this paper, we consider a first attempt to model an equilibrium in a financial market where agents receive direct utility from stock ownership.
We do not model the specific reason for this direct utility. Whether it is product appeal, ideological causes, or loyalty, is left unspecified. The resulting equilibrium, however, is indeed consistent with a number of stylized facts, such as misvaluation, the value effect, and volume premia in the cross-section of stock returns. The drawback of the model is the exogenous nature of the appeal of a stock to an investor. However, the advantage is that it opens up new vistas in explaining stock market phenomena relative to the rigidities imposed by the traditional utility-of-wealth settings.
When agents care about stock ownership directly, the expected return on occasion can turn negative. This raises the specter that in a repeated, dynamic setting, agents might go bankrupt in the long-run. While we do not address this possibility directly, it is worth noting that in other models of financial markets, e.g., Kyle (1985) and its various extensions, it is common to assume some agents earn negative expected profits. We merely endogenize the source of such a phenomenon, and leave the intertemporal aspects for future work. We note, however, that our model predicts negative expected profits only in stocks where agents derive extreme utility or disutility from stock ownership. In the intermediate cases, profits can be zero or positive. This mitigates the tendency for overall bankruptcy in a portfolio setting.
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