Ignacio Palacios-Huerta, assistant professor of economics, teaches Brown students about financial markets, and recently spoke with the George Street Journal’s Kristen Cole about the recent fluctuations in the stock market.
Is it true that many Americans now have investments?
Contrary to popular opinion, few Americans hold a significant amount of money in the stock market besides their pensions. The data shows that today at most 8-10 percent of U.S. households hold more than $10,000 in the stock market, and that these households are the very rich, those at the top of the income distribution. The proportion of individuals that really suffer and really enjoy the fluctuation in the stock market is very small.
It has been noted that Americans appear less prepared than ever to weather the economic slowdown due to a variety of factors, including low savings rates and high personal debt. What lessons should Americans take from the market downturn?
I disagree with the perception that Americans are less prepared than ever before. For instance, low savings rates and high personal debt have characterized the last few decades of the U.S. economy and many other developed countries. So this is not unusual. In my view, a serious shortcoming of these and other "financial" statistics is that they completely ignore savings and wealth accumulated in the form of human capital, rather than financial capital. Human capital has been accumulated at record levels during the last decade and a half. Various economists have estimated that somewhere between 75 to 90 percent of all the wealth of the United States is now in the form of human capital (education, experience, skills). Financial wealth represents less than 5 percent of all the wealth. So, even very large fluctuations in the stock market (say a 10 percent drop) will not be able to erode but a small proportion of individual and aggregate wealth, unless the value of individuals human capital also changes. And it is not conceivable that the value of human capital fluctuates at daily, weekly, or monthly frequencies the way the stock market does.
In general, investors have been advised to do nothing with their stocks up to this point. Do you think that type of message can impact the market for the better?
Yes, I think so. And I basically agree with the advice.
What must happen to the market before that message changes and people are told to sell?
It is difficult to know what is in the minds of some financial advisors. Unless a client, for whatever reason, has a short investment horizon or a high demand for liquid assets, one should not advise a client to hold a large proportion of their monetary wealth in quasi-riskless assets such as bonds and Treasury bills. There is a positive, sizable risk premium that compensates individuals for bearing risks (the so-called equity premium) that has made and continues to make stocks dominate all riskless assets in the mid- and long-term. This has been the case during the last several decades in the U.S. economy and European countries despite much greater fluctuations in the stock market than the ones we have seen recently.