2. Literature review and Hypothesis
2.1 Literature review
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立 政 治 大 學
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N a tio na
l C h engchi U ni ve rs it y
2. Literature review and Hypothesis
2.1 Literature review
There have been an ongoing debate among researchers concerning the link between stock market and demographic changes. In the US, in particular, much has been said about the relationship between the baby boom generation retirement savings and the phenomenal increase in financial asset prices which characterized the period from 1990 to 1999. As Dent (1993), Shiller (2000), and Sterling and Waite (1998) have suggested, the rise in the US stock market during the 1990’s was at least partly due to the post-war baby boom cohort who had entered into their prime earning years and begun saving for their retirement (see graph 1). Abel (2003) also finds empirically that a baby boom will increase the price of capital. Specifically, when baby boomers are in the labor force earning wage income, national saving and investment are high.
Many academics had developed theoretical hypothesis trying to support and explain such linkage. There are four well recognized hypothesis among this subject:
life cycle hypothesis of saving, behavioral lifecycle hypothesis, life-cycle investment hypothesis and life-cycle risk aversion hypothesis. We summarize each of their main concept in the following context.
Life-cycle hypothesis of saving
The intuition behind the link between changing demographics and financial asset
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market is the life cycle hypothesis of saving (see Modigliani and Brumberg (1954) and Ando and Modigliani (1963)) which suggests that early in one’s life, consumption may well exceed income as individuals may be making major purchases like buying a new house or starting a family, and beginning a career. At this stage in life, individuals may borrow based on their expected labor income in the future (human wealth). When comes to mid-point in life, labor income increases while these expenditures begin to level off. Individuals at this stage repay debts and start to save for retirement in stocks, bonds, pension schemes which makes middle-aged households the most prominent investors. At retirement, income normally decreases, and individuals may start to withdraw savings. This involves selling off some of their financial assets. The empirical evidence (Modigliani (1986)) supports the essential idea that consumers want to smooth consumption over time in order to maximize their lifetime utility and, thus, have a hump-shaped saving pattern.
Behavioral Lifecycle Hypothesis
Follows on from Lifecycle theory of saving by Modigliani and Brumberg, the Behavioral Lifecycle Hypothesis (Shefrin & Thaler 1988) holds that households treat components of their wealth as non-fungible. Specifically, wealth is assumed to be split into three mental accounts: current assets, current income, and future income. The propensity to spend money is assumed to be greatest from current income and least from future income. They further suggest that the marginal propensity to consume dividend income is greater than the marginal propensity to consume capital gains of stock holdings. Assuming the BLC theory holds true, it’s more likely that investors substitute more defensive, income yielding assets for out of risk assets as they retired.
Moreover, as long as the assets can generate sufficient income for investors to live off,
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there would be no necessary for them to sell them. As a result, one would expect stocks with lower level of risk and stocks with higher steady cash flows to be less affected by demographic changes.
Life-cycle investment hypothesis
The life-cycle investment hypothesis suggests that the investment needs in terms of types of assets to hold are different at different stages of an investor's life cycle. At the 20s and 30s, housing and other durables are desirable investment. Therefore, one will allocate a higher proportion of wealth to these consumption at the family-building stage. However, the demand for housing will eventually stabilize or even decrease and the demand for financial assets will rise. This is clear to understand. As one grows older, the number of remaining paychecks declines and the need to invest for retirement increases. Over the past decades, this need was made even stronger by the ever -increasing life expectancy. The implication of life-cycle investment hypothesis is very simple, as the population ages, the aggregate demand for housing decreases which depresses housing prices, while that for financial investment increases, which boost financial prices.
Life-cycle risk aversion hypothesis
Bakshi and Chen (1994) proposed the life-cycle risk aversion hypothesis, which suggests that risk aversion will increase over the lifecycle – the older a person gets, the more risk averse they become. Explanation among this theory lies in the relative importance of labor income and asset income over the lifecycle. It have been said that the further a person is from retirement the more risk they are willing to accept in their
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investments since the number of paychecks they expect to receive is large and labor income can offset any unexpected adverse investment outcomes. Otherwise, the closer to retirement a person reaches, the fewer paychecks they have to cover any such adverse investment outcomes. In the empirical tests, they used Euler equations and a two-factor model based on consumption growth and percentage change in average age, and found a positive and statistically significant relationship which strongly supported their life-cycle risk aversion hypothesis. The implication for this is clear. To get an aging population to participate in the equity market, expected premiums must increase. Davis (2007) found that ageing tends initially to benefit equities (as the 40-64 cohort grows) but then as the 65+ cohort becomes predominant, it will rather benefit bond markets relative to equity markets, which is consistent with risk aversion effects.
Overall, the life cycle hypothesis of saving and the life-cycle investment hypothesis both suggested a tendency that young adults and retired people keep financial market away and middle-aged adults are the most promising investor.
The behavioral lifecycle hypothesis further suggested that the marginal propensity to consume dividend income is greater than consume capital gains of stock holdings which implies income yielding stocks would be resilient to impact of demographic changes. On the other side, the life-cycle risk aversion hypothesis proposed that risk aversion will increase over the lifecycle.
Empirical studies
Followed by these hypothesis, many empirical studies were implemented to find statistical back up and tried to put them to a greater extent.
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Yoo (1994) estimated multivariate time-series regressions of annual U.S. stock, corporate bond, and government bond returns on fractions of total population for the 25–34, 35–44, 45–54, 55–64, and 65+ age groups by using an overlapping generations model. He found a strong result the negative relationship between the size of the middle aged group (45-54) and the low frequency returns on financial assets including common and small corporate stocks, long corporate bonds, and long government bonds. He further estimated the regressions with three- and five year centered moving averages and found a significant increase in terms of both statistical significance and fit. Which motivate us to impose the long horizons estimation in our test.
Erb, Harvey, and Viskanta(1997) found the relationship between demographic change and real stock returns on cross-national data for the period 1970-1995 at 18 developed and 45 developing countries. The authors presented evidence suggesting that there is a positive correlation between the fraction of the population between the ages of 25 and 45 and real stock returns in the United States, and this also holds for the fraction 65+ and real stock returns. They found a negative relationship between the population share 45-65 and stock returns in the data sample. Finally, a positive relationship in both developed and developing countries between stock returns and the change in the average age of a country's inhabitants is also suggested.
Using both a short panel (1970–2000; 15 countries) and a long panel (1900–2001;
5 countries), Ang and Maddaloni (2003) examined the relationship between excess stock returns (with one-, two-, and five-year horizons) and log changes in three demographic variables: average age of the population over 20, fraction of adults over 65, and fraction of people in the 20–64 age group. Their results found a negative effect for the fract io n of retirees in the populat ion (65+) in poo led regressio ns.
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國立 政 治 大 學
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N a tio na
l C h engchi U ni ve rs it y
Interestingly, they captured an opposite and positive result in isolated regressions for the United States and the United Kingdom. By an additional test for this difference in results, they found that the effect for the 65+ age group is stronger in countries with well-developed social security systems and less developed financial markets.
Brooks (1998) focused on the determination of the level of equity prices in 14 OECD countries using the share of the 40-65 age group in the population as an independent variable, and found it to be significant for 11 countries. Brooks (1998) calls the positive correlated relationship between asset prices and the size of the cohorts as the ‘life-cycle hypothesis of saving’.
Goyal (2004) modeled the investments in the stock market in an OLG model with wealth effects in which each generation has more than two periods to live. He found outflows from the Stock Market are positively correlated with changes in the fraction of old people and negatively correlated with changes in the fraction of middle-aged population. In addition to a decrease in outflows from the stock market with an increase in the middle-aged population, the stock prices are postulated to rise. Furthermore, in absence of fundamental changes, the long horizon returns are predicted to fall.
The empirical tests confirm these suggests. Stock returns increase following an increase in the middle-aged population and decrease following an increase in the old-age population. However long horizon returns are also negatively correlated with an increase in the middle-aged population, and positively correlated with a decrease in the middle-aged population.
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國立 政 治 大 學