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Policymakers should harness the stock market’s potential as a wealth equaliser

Theo Vermaelen
Theo Vermaelen12/4/2017 08:00 AM GMT+08  • 6 min read
Policymakers should harness the stock market’s potential as a wealth equaliser
SINGAPORE (Dec 4): Currently, one of the greatest sources of inequality is the huge disparity between the returns from holding stocks and holding cash. Interest rates are extremely low so that they hardly compensate for inflation while stock markets are b
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SINGAPORE (Dec 4): Currently, one of the greatest sources of inequality is the huge disparity between the returns from holding stocks and holding cash. Interest rates are extremely low so that they hardly compensate for inflation while stock markets are booming. Finance theory would argue that people should invest a significant fraction of their wealth in a diversified portfolio of stocks, as investing in the stock market will be compensated by a risk premium.

The size of this risk premium is a question of debate but, if the past is a good predictor of the future, one could expect to earn a 5% risk premium above the risk-free rate, which, at a risk-free rate of 2%, translates into 7% per year. At 7%, an investor is expected to double his wealth every 10 years. The fact remains, how­ever, that a large number of individuals do not invest in stocks but save their money instead. The poor, however, are net borrowers; poverty is alleviated by lower interest rates. In order to reduce poverty, one should not increase interest rates but improve the asset allocation of those who can save by encouraging investment in equities. But this idea is typically met by two concerns.

It is not about how much you know
When I ask people why they do not invest more in stocks, the typical answer is that “I know nothing about the stock market”. The implication is that you must be smart to invest in stocks and that wealthy people can hire advisers so that they make better investment decisions. So, the rich will always earn higher returns than the poor. This view is supported by Thomas Piketty in his famous book Capital in the Twenty First Century. On Page 447, he gives the example of university endowments. He ranks endowments by their size and concludes that “the greater the endowment, the larger the return”. He explains this by the fact that the wealthier endowments can afford to pay the salaries of top portfolio managers but the smaller ones cannot.

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