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Photo: Mint

Opinion | Inequality and stock market investments

Policies should encourage the growth of low-cost efficient diversification vehicles that can benefit small investors

Inequality is a defining issue of our times. To get a sense of the scale of this issue, the Credit Suisse Global Wealth Report 2018 tells us that the top 1% of wealthy households in the world hold as much wealth as the bottom 47% of households in the world combined. Just focusing on India, the equivalent percentage of bottom households is greater than 50%, a number that has risen over the past decade.

Why should we care about inequality? For one, studies have connected rising inequality to the rise of extreme politics, anti-immigrant sentiment, and violence. Inequality is also associated with reductions in people’s self-reported happiness. Even without such evidence, inequality is intuitively unpalatable.

Inequality can occur at many levels. The difference between the extremely poor and the rest has naturally been the subject of sustained focus, but there are important differences all along the wealth distribution. Evidence in a recent paper (bit.ly/2GegNxy) shows that there is substantial inequality of wealth even within the middle class in major emerging economies, including India. Moreover, there are very big differences between the middle class and the very wealthy. These facts have serious implications. Inequality of wealth and opportunity can restrict upward mobility, consigning members of the middle class to stagnating incomes. Work on poverty alleviation only gets harder if the middle classes begin to backslide down the wealth distribution.

What drives wealth inequality? An underemphasized force is that the very wealthy can grow their wealth at far higher rates than others. This can happen because the wealthy have access to privileged investment opportunities that aren’t available to those shut out from exclusive “investment networks". There is also often a fixed cost to access better investment opportunities, which is just too high for poorer households to pay. For example, the wealthy frequently have access to high-priced, superior investment advice that is unaffordable to poorer households. Another possibility is that richer households simply make decisions that are more sensible from the perspective of standard finance theory.

In a new paper (Campbell, Ramadorai, and Ranish, 2018, bit.ly/2UJj07x), we use detailed data on the composition of Indian stock portfolios as a useful laboratory to understand the drivers of wealth inequality. Stock investment is an increasingly important vehicle for middle-class and wealthy households in India, and only likely to increase in size and importance. The data covers the decade from 2002 to 2011. During this period, Indians primarily invested directly in stocks rather than through mutual funds or retirement savings vehicles. While this tendency is rapidly changing with recent subscriptions to mutual funds, the lessons that we uncover are still deeply relevant in the more recent period.

The paper documents an enormous difference between the rate of growth of the portfolios of wealthier investors (those with larger portfolios to begin with) and that of less wealthy investors in the Indian stock market.

In 2002 rupee terms, accounts at the 90th percentile (large accounts) grew from roughly 3.5 lakh to 9.4 lakh over the 2002-12 period. However, accounts at the 10th percentile of the distribution (small accounts) actually shrank in size from 3,500 to 2,900 over the same period.

What explains this enormous difference? Interestingly, in terms of the average simple return on investments, small accounts did slightly better than large accounts. Put differently, wealthy investors made slightly worse bets on average, taking risks that weren’t as well compensated as those of poorer investors. This only makes the puzzle worse. The key factor is that larger, wealthier investors were far better diversified over the period. As a result, they were exposed to far less uncompensated risk in their portfolios. This resulted in substantially better performance over the longer horizon, because their stock market wealth just wasn’t as exposed to random fluctuations in individual stocks’ returns.

Essentially, the more efficient diversification of the wealthy lowered their portfolio variance without affecting their average returns. As a stark illustrative example, consider a market with many stocks whose returns are identically distributed, but imperfectly correlated. In such a market, all portfolios will have the same average return, but better diversified portfolios that hold more stocks will have lower variances. This means that better diversified portfolios enjoy a more efficient reward-to-variability ratio—a simplified version of how the rich got richer in the Indian stock market over the period that we study.

The bottom line is that an important force driving inequality of wealth is unsound household finance practices. In this study, we show that by following sensible strategies such as diversification, poorer households can more efficiently grow their wealth. The stock market is just one venue in which this is true, but the lessons are clear—fixing household finance can contribute to important decreases in the inequality of wealth.

A goal of policy should be to encourage the growth of low-cost efficient diversification vehicles that can benefit small investors and reduce the growth of inequality. But rather than more complicated active investment vehicles such as mutual funds, perhaps it is time to provide incentives for simple, low-cost index funds? One might even launch a new campaign: “Index funds sahi hai"!

Tarun Ramadorai is a professor of financial economics at Imperial College Business School, and chaired the RBI Inter-regulatory Committee on Household Finance

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