(8th edition) (the pearson series in economics) robert pindyck, daniel rubinfeld microecon 208

CHAPTER 5 • Uncertainty and Consumer Behavior 183

a point where the expected return on the portfolio exceeds the expected return
on the stock market. In order to hold this portfolio, the investor must borrow
money because she wants to invest more than 100 percent of her wealth in the
stock market. Buying stocks on margin in this way is a form of leverage: the
investor increases her expected return above that for the overall stock market,
but at the cost of increased risk.
In Chapters 3 and 4, we simplified the problem of consumer choice by
assuming that the consumer had only two goods from which to choose—
food and clothing. In the same spirit, we have simplified the investor ’s
choice by limiting it to Treasury bills and stocks. The basic principles, however, would be the same if we had more assets (e.g., corporate bonds, land,
and different types of stocks). Every investor faces a trade-off between risk
and return.16 The degree of extra risk that each is willing to bear in order to
earn a higher expected return depends on how risk averse he or she is. Less
risk-averse investors tend to include a larger fraction of risky assets in their
portfolios.

EX AMPLE 5. 6 INVESTING IN THE STOCK MARKET
The 1990s witnessed a shift in the
investing behavior of Americans.
First, many people started
investing in the stock market for
the first time. In 1989, about 32
percent of families in the United
States had part of their wealth
invested in the stock market,
either directly (by owning individual stocks) or indirectly (through mutual funds
or pension plans invested in stocks). By 1998, that
fraction had risen to 49 percent. In addition, the
share of wealth invested in stocks increased from

about 26 percent to about 54 percent during the
same period.17 Much of this shift is attributable
to younger investors. For those under the age of
35, participation in the stock market increased
from about 22 percent in 1989 to about 41 percent in 1998. In most respects, household investing behavior has stabilized after the 1990s shift.
The percent of families with investments in the
stock market was 51.1% in 2007. However, older
Americans have become much more active. By

2007, 40 percent of people over
age 75 held stocks, up from 29
percent in 1998.
Why have more people started
investing in the stock market?
One reason is the advent of
online trading, which has made
investing much easier. Another
reason may be the considerable increase in stock prices that occurred during the late 1990s, driven in part by the so-called
“dot com euphoria.” These increases may have
convinced some investors that prices could only
continue to rise in the future. As one analyst put
it, “The market’s relentless seven-year climb, the
popularity of mutual funds, the shift by employers to self-directed retirement plans, and the avalanche of do-it-yourself investment publications
all have combined to create a nation of financial
know-it-alls.”18
Figure 5.9 shows the dividend yield and price/
earnings (P/E) ratio for the S&P 500 (an index of
stocks of 500 large corporations) over the period

16

As mentioned earlier, what matters is nondiversifiable risk, because investors can eliminate diversifiable risk by holding many different stocks (e.g., via mutual funds). We discuss diversifiable
versus nondiversifiable risk in Chapter 15.
17

Data are from the Federal Reserve Bulletin, January 2000, and the Survey of Consumer Finances, 2011.

18
“We’re All Bulls Here: Strong Market Makes Everybody an Expert,” Wall Street Journal, September
12, 1997.