Gambling activity and stock price volatility: A cross-country analysis

Abstract

Shiller (2000) contends that gambling activity might promote risk-taking by individuals in other areas, such as firm decision making or in financial markets. In this study, we test the hypothesis that favorable attitudes towards gambling impact country-level stock price volatility. Using American Depositary Receipts (ADRs) to control for differing market structures, we find that countries with more gaming institutions, higher gambling losses per adult, and legalized online gambling have less stable stock prices. These results are robust to different measures of volatility and controls for both firm-specific characteristics and macroeconomic conditions. These findings support the idea that a country’s culture toward gambling might generate greater levels of volatility in the country’s financial markets.

Introduction

A growing body of both theoretical and empirical research suggests that gambling preferences by investors can influence asset prices in financial markets (Scheinkman and Xiong, 2003, Hong et al., 2006, Barberis and Huang, 2008, Kumar et al., 2011, Patton and Sheppard, 2015, Blau et al., 2016). Shiller (2000) argues that increases in gambling activity affect culture and can “change attitudes towards risk-taking (pp. 41)”, which could affect the behavior of prices in the stock market. Shiller (2000) writes that from 1929 to 1933, volatility in the stock market corresponded with a “gambling craze”, suggesting that attitudes toward gambling might be associated with higher levels of volatility in financial markets. Several explanations for this association exist. One explanation is that in cultures with favorable attitudes toward gambling, managers of firms are likely to take greater risks. Companies that take on greater risk will have more variability in their financial performance, which will likely result in less stable stock prices. Another explanation could stem from the findings in Dorn and Sengmueller (2009) that show that investors with stronger preferences for gambling tend to trade stocks more frequently. Numerous studies have documented a positive relationship between trading activity and volatility (Schwert, 1989, Gallant et al., 1992, Karpoff, 1987, Jones et al., 1994). Perhaps excessive trading by investors in places with favorable gambling cultures contributes to the link between gambling activity and volatility. Following these ideas, this study formally tests the assertion in Shiller (2000) that gambling attitudes and activity will lead to greater volatility in financial markets. In particular, we test whether or not countries with favorable gambling cultures have less stable stock prices.

Identifying determinants of volatility has important implications for several reasons. Beginning with Shiller, 1979, Shiller, 1981, several studies have shown that stock prices are more volatile than expected according to standard asset pricing models (LeRoy and Porter, 1981; Singleton, 1980, Grossman and Shiller, 1981, Blanchard and Watson, 1982, Flavin, 1983). Given the abnormally high levels of volatility, testing whether or not gambling activity leads to higher volatility in stock prices could help identify, in part, factors that lead to excess volatility. Furthermore, the abnormal levels of volatility suggest either incomplete models or deviations from traditional explanations, which might stem from cultural characteristics, such as gambling preferences.

Moreover, the implications of our tests may contribute more broadly to our understanding of economic and financial activity. Endogenous growth theory suggests that economic output is a function of aggregate capital stock in the economy. However, the level of capital depends on the level of financial development (Goldsmith, 1969, McKinnon, 1973, Shaw, 1973; and Pagano, 1993). In equilibrium, gross savings in the economy funnels into gross investment, which leads to higher levels of aggregate capital. In the steady-state, economic growth becomes a function of the quality of financial markets. When these markets are excessively volatile, the fraction of gross savings that flow into gross investment might decrease because risk-averse savers are less inclined to invest in capital markets. In that case, unusual volatility in financial markets might reduce gross investment, aggregate capital stock, and ultimately, economic output. Thus, understanding the factors that lead to the instability of asset prices has important implications that are not only important for financial markets but also relate to other economic outcomes.

One of the challenges associated with testing whether cultural factors influence cross-country differences in stock market volatility is the heterogeneity of market structures around the world. Given the role that market structure and economic development play in the volatility of stock markets (see Arestis et al. (2001)), controlling for country-specific factors is critical. To alleviate these issues, we examine the volatility of American Depositary Receipts (ADRs), which are securities that are traded on U.S. stock exchanges but represent shares of foreign companies. The use of ADRs allows us to control for the possibility that the volatility of financial markets in a particular country is endogenously determined by the quality of gambling markets in that country. Additionally, the use of ADRs accounts for the different market structures while at the same time capturing differences in volatility that could be related to cultural preferences. Because ADR prices and the prices of foreign stocks are inherently linked through arbitrage (Kato et al., 1990; Karolyi, 2004), the use of ADRs allows us to examine the volatility of securities while holding the market structure constant but also allows us to exploit the variation in gambling attitudes across ADR home countries. Admittedly, we are not the first to use this research design. For example, Eleswarapu and Venkataraman (2006) find that the strength of political and legal institutions in an ADR home country leads to greater ADR liquidity in U.S. equity markets.

Attitudes toward gambling vary dramatically around the world. At one extreme, countries like many of those in Europe, have very liberal attitudes toward gambling. At the other extreme, countries like Qatar, have very strict laws that attempt to restrict gambling. These types of differences make our tests more compelling. To measure the attitudes toward gambling in an ADR home country, we first gather data on the number of gaming institutions and calculate the ratio of gaming institutions to the population. We also obtain data on gambling losses per adult in countries ranked in the top 10 in the world. Finally, we approximate gambling cultures by determining whether or not a particular home country allows for legalized online gambling.

Results from our univariate tests show a strong and positive relationship between these three measures of gambling and the volatility of ADRs. These results are robust to various measures of volatility. Of the three measures used in our analysis, gambling losses per adult seem to be most strongly associated with increased volatility. However, we find that our results are still robust to the number of gaming institutions and whether or not online gambling has been legalized in the ADR home country.

Our results also hold in both univariate and multivariate settings. Holding constant a variety of ADR-specific and home country-specific characteristics, results from these tests show gambling in the home country is directly associated with the volatility of ADRs. The results from our multivariate tests are not only statistically significant but the findings are also economically meaningful. For instance, a unit increase in the number of gaming institutions in the home country is associated with an increase in volatility that ranges from 5.4% to 7.9% depending on how volatility is measured. When examining the relationship between gambling losses per adult in the home country and the volatility of ADRs, we find that a unit increase in gambling losses increases volatility by more than 20%. Additionally, home countries that allow legal online gambling have ADR volatility that is about 8% higher than home countries that do not allow legal online gambling. These results are consistent with our hypothesis and suggest that countries with more favorable attitudes toward gambling have less stable stock prices. More importantly, these findings contribute to the existing literature by providing support for the assertion in Shiller (2000) that gambling cultures can lead to greater risk-taking and, eventually, affect the volatility of asset prices.

Combined, the results of this study provide an important contribution to our understanding of how gambling cultures influence the volatility of stock prices. Aside from finding support for Shiller’s (2000) argument, our results also contribute to the broad literature that attempts to identify factors that influence volatility (Black, 1976, Christie, 1982, Schwert, 1989, Chan and Lakonishok, 1995, Bekaert and Wu, 2000, Wu, 2001). While this literature generally focuses on the determinants of volatility that are more traditionally firm-specific, the results in our study suggest that more non-traditional factors, such as culture, can influence the stability of stock prices.

A detailed description of our analysis follows. Section 2 provides a discussion of the data used throughout the analysis. Section 3 presents our empirical tests and results. Finally, Section 4 provides some concluding remarks.