Neighbourly rivalry is felt on the stock exchange

1 December 2009

We don't want to take a back seat to our neighbours. This phenomenon explains why we prefer domestic shares and are willing to pay more for them, claims professor Richard Priestley at BI.

RESEARCH @ BI: Asset pricing

We may or may not be aware of it ourselves, but many of us keep a close eye on what our neighbours are up to. For example, it rarely goes unnoticed if she buys a new, sportier car. Is your neighbour upgrading his kitchen or buying a spiffy new gas stove? Or maybe a nice cabin in the mountains or by the sea?

We simply can't stand being overtaken by Hansen, our neighbour.

In English, this phenomenon is referred to as ”Keeping up with the Joneses”, (with Jones being a common surname in the English-speaking world, much like Hansen is in Norway).

Mysteries in the world of finance

Professor Richard Priestley at BI Norwegian Business School has worked together with financial researchers Juan Pedro Gomez and Fernando Zapatero to develop a model to examine whether our penchant for comparing ourselves with our neighbour can explain a few of the mysteries that prevail in the world of finance.

Financial theory dictates that, in a world with open financial markets, investors' best bet is to spread risk over multiple shares in different markets (to have a diversified, international portfolio).

This allows the investor to remove the country-specific risk associated with the share market.

However, the investors don't seem to follow the dictates of theory:  Quite often, they do not have a diversified international share portfolio and they appear to prefer their own domestic shares.

Different strokes

Priestley and his research colleagues leave out one of the assumptions of financial theory: that investors have the same preferences regardless of where in the world they operate.

Instead, they launch the idea that investors aren't just interested in maximising share wealth, but also in how they are performing compared with other players in their home country.

The premise of the theoretical model proposed by the financial researchers is that there are some who do not operate in the share market (some workers and entrepreneurs), with whom they compare themselves.

"We find that the investors' share portfolios vary from country to country. This means that national preferences may exist in an equilibrium," says Richard Priestley.

The BI professor also says this explains that, under otherwise equal conditions, there may be a country-specific share risk in addition to the global risk associated with owning shares. This country-specific risk depends on the income level of those who do not have access to the financial markets.

Willing to pay extra for local shares

The financial researchers have tested their model against empirical share data from Germany, Japan, the United Kingdom and the USA, and have found substantial support for their assumptions.

"Our empirical tests show that investors are interested in how much they earn compared with others. Investors are willing to pay extra for domestic shares that allow them to "keep up with the Joneses”. This explains the country-specific risk associated with shares," says Richard Priestley with BI Norwegian Business School.

It does not come as a surprise, then, that the typical investor seems to have more domestic shares in her portfolio than would have been the case if she were only interested in maximising capital gain.

Reference:
Gomez, Juan Pedro, Richard Priestley and Fernando Zapatero. 2009. Implications of Keeping up with the Joneses. Behavior for the Equilibrium Cross Section of Stock Returns: International Evidence. Forthcoming in The Journal of Finance.

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