Learning and Stock Market Participation

By. Juhani Linnainmaa

This paper examines the impact of short-sale constraints on market participation when agents learn about their investment opportunities. The possibility of binding short-sale constraints creates a feedback that can keep agents out of the market even if the risk premium is high. This effect arises with learning because the changes in investment opportunities are correlated with future realized outcomes: an agent will have a poor investment opportunity set precisely in those future states where her marginal utility is high. Non participation arises also in an equilibrium model where agents resolve uncertainty about the cash-flow covariance between tradable and non-tradable assets. These results suggest that learning and short-sale constraints can simultaneously generate non-participation, a sizable risk premium, and insignificant contemporaneous correlation between the stock return and the income of those who do not participate in the stock market.