Can We Blame the Stock Market for Income Inequality?

Source: iStock

Source: iStock

“The rich are getting richer and the poor are getting poorer,” — it’s a phrase you’ve probably heard a time or two. Most people have probably heard it so many times, in fact, that it’s become a cliche. Whether it’s true or not is up for debate, but it’s definitely true that income inequality has become a larger issue in American society. Essentially, it’s why 1% of the world’s most wealthy people control 98% of the world’s wealth and assets.

You can make the case for a million reasons about how this gap began and why it’s persisted for several decades, the chasm growing wider every year. But a recent paper by a few finance researchers suggests it really boils down to one thing: good information, and being able to pay for it.

The researchers hail from the National Bureau of Economic Research, Columbia University, and the University of Maryland, and focused on the fact that the rich are able to compound their wealth by setting up stellar investment portfolios. In other words, the rich get rich and stay that way because they’re better at investing, and because they can pay to have the advantage of good information.

Source: Center on Budget and Policy Priorities

Source: Center on Budget and Policy Priorities

In the paper, “Investor Sophistication and Capital Income Inequality,” the authors use the term “sophisticated investors” for those people who have access to financial advisors, or who are advisors themselves. They can afford to pay for sound, solid financial advice about where to invest their money, because they’re rich to begin with. More often than not, that good advice leads to higher returns on their investments, which yields more money overall. Meanwhile, the unsophisticated struggle to get that good information on their own, and then are typically priced out of the investments once they get there.

“Intuitively, if information about financial assets and its processing are costly, individuals with different access to financial resources will differ in terms of their capacity to acquire and process information,” the authors explain. “Sophisticated investors have access to better information which allows them to earn higher income on the assets they hold.”

This cycle continues to spiral outward, and the key factor is that sophisticated investors have the information they need to learn more, faster. “The more an investor knows, the easier it is for her to learn on the margin. As a result, the effects from our first prediction are additionally strengthened because sophisticated investors already start from a higher level of capacity to process information,” the authors write.

This information gap will continue to widen as well, which is what Bloomberg columnist Noah Smith said is perhaps most worrying about the cycle. “As society’s average level of sophistication goes up, information-driven inequality may increase. This will happen if informational advantages build on each other — the more you know, the better you understand how to learn more,” he writes.

Source: "Investor Sophistication and Capital Income Inequality" paper

Source: “Investor Sophistication and Capital Income Inequality” paper

That’s why this problem is essentially a catch-22. Arguably, the best way to give unsophisticated investors a leg up is to improve their financial literacy — to give them more information to make better investments. But an increased amount of information helps everyone in society, not just the disadvantaged. That increased information will also help the rich, who are still able to pay for the cream of the crop of investment tips. So the income gap from those investments will just continue to grow. The graph above shows sophisticated investors have been beating unsophisticated investors in their stock market returns for more than a decade.

What’s more, less sophisticated investors with less money to invest have also stopped investing as much. According to the paper’s authors, the flow of money into mutual funds from people investing less than $100,000 dropped 70% from 2000 to 2012.

The growth of investment resources for everyone and competition across types of investors is normally seen as a positive sign of a healthy financial market, the authors admit. However, the conclusion of the authors is that policies which seek to increase financial information might actually widen the income gap, not close it.

In reality, what has seemed unfair all along might really be that way. The rich can afford to pay for better information, and keep getting richer as a result. And that same information in the hands of the unsophisticated would only boost the investing abilities of everyone, making it extremely difficult for unsophisticated investors to make any comparative gains.

Follow Nikelle on Twitter @Nikelle_CS

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