Rich people get richer because they earn lower returns in the stock market

Many believe that wealth inequality is the defining issue of our time. Economists like Thomas Piketty argue that the owners of capital are set to earn such high returns on investment that inequality will get even worse. But whether the rich actually earn higher returns than the rest of us is not well established.

A new paper looks at the Indian stock market to measure whether wealthier investors earn higher returns and, if so, how much this contributes to inequality. Wealth inequality among owners of equity in India has widened between 2002 in 2011: Over that period, the authors estimated that the 10th percentile of accounts fell in value, from $71 to $60, while the 90th percentile jumped in value, from $7,274 to $19,258.

The economists tried to figure out how much of the growing inequality was due to rich people earning higher returns and how much stemmed from having more wealth to buy stocks in the first place. What is surprising is that the smaller account holders earned higher returns, on average. The smallest accounts earned a 1.85% excess return—the return on stocks above what a low-risk bond would pay. The largest accounts only earned a 1.76% average excess return.

Those higher returns reflected small account holders’ riskier portfolios. The smaller accounts held fewer stocks, on average 1.89 stocks per account. The larger accounts held 16.1 stocks. More stocks mean more diversification, which implies less risk.

Even if they generated a smaller average return, the more diversified portfolios built more wealth. That’s because in any given year a riskier portfolio might offer a higher return, but in other years years it will probably lose money. The well-diversified portfolio, by contrast, performs better consistently. Consistent growth generates higher returns over time through the benefits of compounding. The authors of the study concluded that differences in diversification accounted for most of the widening in wealth inequality among investors in the Indian stock market.

The stereotype of rich investors is they know the right stocks to pick, or can hire managers to do it for them. But the research suggests that investors who go with basic diversification strategies perform better, even if some years their returns seem unspectacular. Wealthier Indians embraced diversification and were rewarded accordingly.

Under-diversification is not limited to developing countries like India. Just over 50% of Americans invest in the stock market, and around 30% of people who own equity buy individual stocks, according to 2016 data from the Federal Reserve. Among the stock-pickers, richer Americans, like their Indian counterparts, are more diversified: investors in the top 10% of net worth own an average of nine stocks, while investors in the bottom 10% own just five.

In general, though, American investors are more diversified because of the widespread availability of mutual and index funds. These funds, which tend to hold broad-based baskets of stocks, are less common in emerging markets. If policymakers want to reduce inequality, they should consider ways to encourage investors—especially those just starting out—to buy index funds instead of individual stocks.