Wider Share Ownership
Too many eggs, one portfolio

Direct ownership of shares by individuals in the United Kingdom has declined from 54% of the market in 1963 to 28% in 1981. The present Government is committed to reversing this decline through various schemes to encourage wider share ownership. Since 1981, the number of individuals owning shares has indeed risen considerably, mostly as a result of the privatization programme, although the proportion of equities they own has not changed substantially. Wider share ownership will have far-reaching effects, it is claimed, helping to create an 'enterprise culture' and transforming attitudes to wealth-creation. It is difficult to predict whether these long-term goals will be attained, but at a lunchtime meeting on 5 February, Paul Grout examined the immediate obstacles to wider share ownership and its likely effecs on the UK stock market.

Paul Grout is Professor of Economics at Bristol University and a Research Fellow in CEPR's Applied Economic Theory and Econometrics programme. He is the author of several publications on shareholding, investment, savings and employment, and (with Saul Estrin and Sushil Wadhwani) of 'Profit-Sharing and Employee Share Ownership', in Issue No. 4 of Economic Policy (available in April). The lunchtime meeting at which he spoke was sponsored by the German Marshall Fund of the United States.

There are two principal arguments which suggest that wider share ownership may benefit the economy, Grout observed. There is evidence that the stock market is myopic and that share prices respond too much to short-run developments (for example, Discussion Paper No. 155 by Stephen Nickell and Sushil Wadhwani). It seems that individuals, because they face higher transaction costs, revise their portfolios less frequently than do institutions. A recent survey indicated that, although they check their share values frequently, 45% of individuals directly owning shares had made no transactions at all in the last year. This contrasts dramatically with the turnover rate of unit trusts (about twice the average for the market) and lends some strength to the Chancellor's view that wider share ownership may encourage a longer-term perspective on the part of investors. Grout agreed: even taking into account that turnover rates are likely to be lowest among those shareholders with the least wealth, the tendency of wider share ownership to reduce the rate of turnover in the stock market should encourage both more and longer-term investment in the United Kingdom.

Wider share ownership may therefore be desirable, but it may also have harmful side-effects, according to Grout. It may lead to less frequent trading in some equities; the markets in these shares are said to become thinner. Prices are generally more volatile in thin markets, so wider share ownership will not necessarily reduce share price volatility. (For further work on market thinness see Discussion Paper Nos. 142, 144 and 146, by Marco Pagano, reported in this Bulletin.) The decisive question is whether companies respond differently to increased share price volatility if they know it reflects market thinness and that most shareholders take a longer-term view of the value of the company. If companies do take this view, then the policy of wider share ownership will be well on the way to achieving its objective, Grout argued. But if not, then the important potential benefit of a longer-term perspective on investment decisions may not be realized.

Wider share ownership may affect equity markets in other ways. Grout argued that privatization may increase the demand for equities in general. Investing in equities can involve important initial information costs, to learn how to buy and sell assets. Grout had estimated that an individual's first transaction reduced the information costs of undertaking the next transaction by around 72%, and the second transaction reduced this again, by a further 53%. After engaging in a very few transactions, therefore, an individual is likely to respond differently to the same set of asset prices. The attractive terms of recent privatizations may offset the high initial information costs faced by new shareholders, Grout argued, and thus increase the overall demand for equities. If this higher demand is partly met by individuals permanently reducing their consumption then the privatization programme will have less of a long-term crowding- out effect on investment than if the government were to raise the same money through conventional borrowing, and the level of investment in the economy will increase as a result.

The need to hold a diverse portfolio of assets may be an obstacle to wider share ownership. Portfolio allocation theory suggests that risk-averse investors with no inside information should invest in every security. Indeed the most popular model of security prices, the capital asset-pricing model, implies that all investors should hold the same mix of risky assets in their portfolio. Individuals with small asset holdings may be unable to achieve such extensive diversification; this is often seen as a major drawback to wider share ownership. Grout argued, however, that the importance of diversification in shareholdings as an obstacle to wider share ownership is overstated, except for individuals with a very small quantity of wealth. Diversification allows investors to avoid the risks associated with particular firms (the firm-specific risk). In practice, this risk can be minimized by holding shares in perhaps only ten to fifteen different firms. In addition, the diversification argument is of less consequence if transaction costs are significant or if shares are held for long periods without revising the composition of the portfolio.

The 'enterprise culture' is intended to make profits more acceptable and change attitudes to wealth-creation among both workers and employers. The need for a diversified portfolio of assets may restrict share ownership among these groups. The individuals whose attitudes the Government most wants to change are the least likely to be attracted to share ownership, Grout suggested. Portfolio allocation theory analyses an individuals' holdings of all assets; for many individuals the major components of this broad portfolio will be human capital, housing and pension rights.
Trade union bargaining power and the specialized nature of some skills mean that a large part of an individual's human capital is firm-specific, valuable only when the individual is employed in a particular firm. In effect, workers hold a large proportion of their wealth as a single 'share' (in their employer's firm) which cannot be diversified away. Grout estimated that this human capital could be valued at about #35,000 for an 'average' working male and about #61,000 for an 'average' working couple. Individuals' investment in housing may be an even more important factor, according to Grout, since housing assets are very illiquid. Housing prices and share prices are both negatively correlated with interest rates, and tend to move together. Risk- averse individuals who already hold a large part of their wealth as housing are therefore unlikely to add stocks to their portfolio; they would prefer to diversify by purchasing assets whose price is negatively correlated with that of their property. Holdings in pension funds are much less subject to this constraint, Grout noted, since the long-term relationship between pension values and interest rates is both vague and complex.

Existing portfolios are therefore dominated by property and firm- specific human capital. Wider share ownership would tend to concentrate the risks associated with such portfolios. This concentration will limit the extent to which share ownership can be spread more widely, and it is compounded by the present Government's commitment to profit-related pay, employee share ownership and wider home ownership. Owner-occupation, variable interest rate mortgages and, arguably, labour market imperfections are more important in the United Kingdom than elsewhere. The maximum achievable spread of share ownership may therefore be lower in Britain than in many other European countries, Grout concluded.

Some members of the audience felt that insufficient encouragement was given to individuals to purchase shares: fiscal incentives were needed to balance the concessions offered to home ownership and to pension funds. The next logical step to wider share ownership, after the privatization programme, may be to encourage 'blue chip' private companies to make their shares available to individual investors. But this would require fiscal incentives, it was suggested, to induce the financial institutions to give up their first options on such shares. It was also argued that privatization only teaches new shareholders how to participate in the privatization programme and does not reduce the information costs involved in purchasing equities more generally.

Was the stock market really the best method of controlling management? In West Germany, for example, where banks are the major source of industrial investment, control over company policy is very effective. Grout was concerned that the recent growth of incentive schemes in the United Kingdom, which reward top managers on the basis of movements in their company's share price, would increase 'short-termism'.