NBER WORKING PAPER SERIES
NEIGHBORS MATTER:
CAUSAL COMMUNITY EFFECTS AND STOCK MARKET PARTICIPATION
Jeffrey R. Brown
Zoran Ivkovich
Paul A. Smith
Scott Weisbenner
Working Paper 13168
http://www.nber.org/papers/w13168
NATIONAL BUREAU OF ECONOMIC RESEARCH
1050 Massachusetts Avenue
Cambridge, MA 02138
June 2007
We thank Bo Becker, Josh Coval, Caroline Hoxby, Jeff Kubik, Erzo Luttmer, Ulrike Malmendier,
Jennifer Marietta-Westberg, Tobias Moskowitz, Josh Pollet, Rob Stambaugh, Annette Vissing-Jorgensen,
and seminar participants at the 2004 Western Finance Association annual meetings, the 2005 People
& Money: The Human Factor in Financial Decision-Making conference at DePaul University, the
2007 American Economic Association meetings, Harvard University, Michigan State University, Ohio
State University, the University of Illinois, the University of Michigan, the University of Virginia,
and the University of Wisconsin for their useful comments. The analysis for this paper was completed
while Paul Smith was an economist with the Office of Tax Analysis at the U.S. Department of Treasury.
We thank Jim Cilke for assistance with the tax data and Jean Roth of the NBER for expert assistance
with the Census data.¸ The views expressed herein are those of the author(s) and do not necessarily
reflect the views of the National Bureau of Economic Research.
© 2007 by Jeffrey R. Brown, Zoran Ivkovich, Paul A. Smith, and Scott Weisbenner. All rights reserved.
Short sections of text, not to exceed two paragraphs, may be quoted without explicit permission provided
that full credit, including © notice, is given to the source.
Neighbors Matter: Causal Community Effects and Stock Market Participation
Jeffrey R. Brown, Zoran Ivkovich, Paul A. Smith, and Scott Weisbenner
NBER Working Paper No. 13168
June 2007
JEL No. G11
ABSTRACT
This paper establishes a causal relation between an individual's decision of whether to own stocks
and average stock market participation decision of the individual's community. We instrument for
the average ownership of an individual's community with lagged average ownership of the states in
which one's non-native neighbors were born. Combining this instrumental variables approach with
controls for individual and community fixed effects, a broad set of time-varying individual and community
controls, and state-by-year effects, rules out alternative explanations. To further establish that word-of-mouth
communication drives this causal effect, we show that the results are stronger in more sociable communities.
Jeffrey R. Brown
Department of Finance
University of Illinois at Urbana-Champaign
340 Wohlers Hall, MC-706
1206 South Sixth Street
Champaign, IL 61820-9080
and NBER
brownjr@uiuc.edu
Zoran Ivkovich
Department of Finance
University of Illinois
340 Wohlers Hall
1206 South Sixth Street
Champaign, IL 61820
ivkovich@uiuc.edu
Paul A. Smith
Federal Reserve Board of Governors
Washington, DC 20551
Paul.A.Smith@frb.gov
Scott Weisbenner
Department of Finance
University of Illinois, Urbana-Champaign
304C David Kinley Hall
1407 W. Gregory Drive
Urbana, IL 61801
and NBER
weisbenn@uiuc.edu
Standard models of portfolio choice typically assume that fully informed investors make rational
asset allocation decisions to maximize lifetime utility. As noted by Ellison and Fudenberg
(1995), however, “economic agents must often make decisions without knowing the costs and
benefits of the possible choices” and thus often “rely on whatever information they have
obtained via causal word-of-mouth communication.” Given the evidence that average U.S.
citizens have limited investment knowledge,
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might individuals make portfolio choice decisions
based on what they have learned from social interactions?
This paper empirically examines the influence of “community effects,” in the form of
word-of-mouth communication, on the decision about whether to participate in the stock market.
In addition to its importance at the individual level, equity market participation is also important
at the aggregate level because of its ability to influence the size of the equity premium (Mankiw
and Zeldes (1991), Heaton and Lucas (2000), Brav, Constantinides, and Gezcy (2002)). It is also
relevant for a variety of public policies, ranging from the incidence of dividend tax policy to
whether investing Social Security surpluses in private investments can have real effects on the
economy (Abel (2001), Diamond and Geanakoplos (2003)).
Whereas standard models of portfolio choice indicate that most households should have
equity market exposure, only one-third of U.S. households own stocks or stock mutual funds
outside of retirement plans, and only one-half participate in the stock market even when
retirement plans are included into the calculation.
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There are numerous reasons to suspect that
one’s decision about whether or not to invest in stocks may be influenced by the stock market
participation of one’s community by means of social interaction. Hong, Kubik, and Stein (2004)
present a formal model and discuss several possible pathways for this effect. For example, social
interaction may serve as a mechanism for information exchange by means of word-of-mouth
communication or “observational learning” (Banerjee (1992), Ellison and Fudenberg (1993,
1995)). Simply put, individuals may find it easier to learn how to open a mutual fund or
brokerage account by talking to their friends than through other mechanisms. This could lower
the psychological “fixed costs” of investing that limit equity market participation (Vissing-
Jorgensen (1999)). Individuals may also enjoy discussing stock-market investments with their
friends and colleagues and thus may be more likely to participate in the stock market if there is a
high participation rate among their friends and colleagues. There may also be a “keeping up
with the Joneses” effect. For example, according to Bernheim’s (1994) model of conformity,
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individuals may wish to maintain the same consumption that their social group does, suggesting
that participation in the stock market by their social group may have a positive influence on their
own decision to do so. This effect could also be generated by external habit formation models
(Campbell and Cochrane (1999)) or the scarcity of local resources that lead investors to care
about their relative wealth in the community (DeMarzo, Kaniel, and Kremer (2004)). Each of
these forms of word-of-mouth interaction imply a possible causal relation between individual
and community behavior.
In this paper, we establish a causal relation between individual and community stock
market participation by showing that an individual is more likely to participate in the stock
market when a higher fraction of individuals in the local community are stock market investors.
To establish causality, one must rule out many other confounding factors (such as similarity in
preferences or information sets) that could lead to a spurious correlation between one’s own
stock market participation and that of one’s neighbors.
The previous literature has not provided conclusive evidence on this matter. Guiso,
Sapienza, and Zingales (2004) show that individuals who live or were born in areas with higher
levels of social capital are more likely to invest in stocks, but they do not directly test whether
higher stock market participation of one’s neighbors directly influences one’s own decision.
Whereas Hong, Kubik, and Stein (2004) show that individuals who visit with neighbors or attend
church have higher levels of stock market participation, and that this effect is stronger for
individuals who live in more sociable states, concerns linger about the potential for unobserved
characteristics to be driving both stock market participation decisions and their measures of
social interaction. For example, Gruber (2005) shows that religious participation (one of the
measures of sociability used in Hong, Kubik, and Stein (2004)) is correlated with income,
education, marital status, and other variables, all of which may be correlated directly with stock
market participation. Feng and Seasholes (2004) use data from the People’s Republic of China
to show that common reaction to public information, rather than word-of-mouth effects, seems to
be a primary determinant of investors’ trading behavior. Thus, whether social interaction
influences stock market participation is far from settled.
A major reason why the prior literature has not provided conclusive evidence of a causal
relation is that, as discussed extensively by Manski (1993, 1995), it is difficult to design an
empirical strategy that overcomes the inherent identification problem. The concern is that,
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because individuals are not randomly assigned to communities, the observed correlation between
the stock ownership of an individual and his community could reflect numerous unobservable
influences that induce a spurious correlation even after controlling for observable characteristics.
In this paper, we use a large, nationally representative, 10-year panel data set of taxpayers
to provide evidence of an economically and statistically significant causal community effect of
stock market participation. We do so by simultaneously implementing an instrumental variables
strategy that overcomes the endogeneity problem and controlling for a very broad set of
observable and unobservable individual and community characteristics. Our instrument is
motivated by Guiso, Sapienza, and Zingales (2004), who suggest that the social capital of one’s
birth region can have long-lasting effects on one’s own financial decisions. We begin by
restricting our sample to “native” individuals, that is, those who have lived in the same
community over the entire panel and who still reside in their state of birth.
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We then instrument
for the average ownership within each native individual’s community with the average
ownership of the birth states of “non-native” neighbors, that is, those community residents whose
Social Security numbers were issued in states that do not overlap with their current community
(intuitively, those born in a different community and state). Whereas the average ownership in
the birth states of one’s neighbors will be correlated with the ownership of one’s neighbors
because of the long-lasting effects described above, there is no reason why one’s own stock
market participation decision should be influenced directly by the ownership rates in these other
states except through their effects on one’s neighbors. Because we restrict our sample to
“native” individuals and instrument for the ownership of their community with the average birth-
state ownership of their “non-native” neighbors, we are ensuring that the regression results
cannot be contaminated by an individual and his community members sharing the same
background (i.e., birth state). We also rule out a correlated, contemporaneous response across
communities to new information by using a one-year lagged value of the instrument.
In conjunction with this instrumental variables approach, we include individual fixed
effects to control for observable and unobservable individual characteristics that are fixed over
time, such as gender, race, or average risk tolerance over the sample period. Because our sample
is restricted to “natives” (we also refer to them as “non-movers” interchangeably), the individual
fixed effects also control for time-invariant community characteristics such as the average level
of financial sophistication of a community over the sample period. Thus, we relate changes in
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