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The Foregone Gains of Incomplete Portfolios

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  • Monica Paiella

    ()
    (Bank of Italy, Research Department)

Abstract

This paper estimates a lower bound to the foregone gains of incomplete portfolios, which are in turn a lower bound to the (unobserved) entry costs that could rationalize non-participation to financial markets. My estimates provide a heuristic test for the cost-based explanation of limited financial market participation: high estimates would imply implausibly high participation costs. Using the CEX and assuming isoelastic utility and a relative risk aversion of 3 or less, for the stock market I estimate an average lower bound ranging between 0.7 and 3.3 percent of consumption. Since annual total (observable plus unobservable) participation costs are likely to exceed these bounds, the cost-based explanation is not rejected by this test.

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Bibliographic Info

Paper provided by Centre for Studies in Economics and Finance (CSEF), University of Naples, Italy in its series CSEF Working Papers with number 156.

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Date of creation: 01 Feb 2006
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Handle: RePEc:sef:csefwp:156

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Keywords: intertemporal consumption model; financial market participation; household portfolio allocation; non-proportional cost of participation; near-rationality;

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References

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  1. Mankiw, N. Gregory & Zeldes, Stephen P., 1991. "The consumption of stockholders and nonstockholders," Journal of Financial Economics, Elsevier, vol. 29(1), pages 97-112, March.
  2. Attanasio, Orazio P & Weber, Guglielmo, 1995. "Is Consumption Growth Consistent with Intertemporal Optimization? Evidence from the Consumer Expenditure Survey," Journal of Political Economy, University of Chicago Press, vol. 103(6), pages 1121-57, December.
  3. Hansen, Lars Peter & Singleton, Kenneth J, 1982. "Generalized Instrumental Variables Estimation of Nonlinear Rational Expectations Models," Econometrica, Econometric Society, vol. 50(5), pages 1269-86, September.
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  8. Lucas, Deborah J., 1994. "Asset pricing with undiversifiable income risk and short sales constraints: Deepening the equity premium puzzle," Journal of Monetary Economics, Elsevier, vol. 34(3), pages 325-341, December.
  9. Heaton, John & Lucas, Deborah, 2000. "Portfolio Choice in the Presence of Background Risk," Economic Journal, Royal Economic Society, vol. 110(460), pages 1-26, January.
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  12. Grossman, Sanford J. & Shiller, Robert J., 1982. "Consumption correlatedness and risk measurement in economies with non-traded assets and heterogeneous information," Journal of Financial Economics, Elsevier, vol. 10(2), pages 195-210, July.
  13. James M. Poterba & Andrew Samwick, 2001. "Household Portfolio Allocation over the Life Cycle," NBER Chapters, in: Aging Issues in the United States and Japan, pages 65-104 National Bureau of Economic Research, Inc.
  14. Monica Paiella, 2001. "Limited financial market participation: a transaction cost-based explanation," IFS Working Papers W01/06, Institute for Fiscal Studies.
  15. Fama, Eugene F. & French, Kenneth R., 1989. "Business conditions and expected returns on stocks and bonds," Journal of Financial Economics, Elsevier, vol. 25(1), pages 23-49, November.
  16. Simon, Herbert A, 1978. "Rationality as Process and as Product of Thought," American Economic Review, American Economic Association, vol. 68(2), pages 1-16, May.
  17. Heaton, John & Lucas, Deborah, 1997. "Market Frictions, Savings Behavior, And Portfolio Choice," Macroeconomic Dynamics, Cambridge University Press, vol. 1(01), pages 76-101, January.
  18. Annette Vissing-Jorgensen, 2002. "Limited Asset Market Participation and the Elasticity of Intertemporal Substitution," NBER Working Papers 8896, National Bureau of Economic Research, Inc.
  19. Merton, Robert C, 1969. "Lifetime Portfolio Selection under Uncertainty: The Continuous-Time Case," The Review of Economics and Statistics, MIT Press, vol. 51(3), pages 247-57, August.
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  22. Monica Paiella, 2003. "Revisiting the Implications of Heterogeneity in Financial Market Participation for the C-CAPM," Temi di discussione (Economic working papers) 473, Bank of Italy, Economic Research and International Relations Area.
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Citations

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Cited by:
  1. Luigi Guiso & Paolo Sodini, 2012. "Household Finance. An Emerging Field," EIEF Working Papers Series 1204, Einaudi Institute for Economics and Finance (EIEF), revised Mar 2012.
  2. Orazio P. Attanasio & Monica Paiella, 2007. "Intertemporal Consumption Choices, Transaction Costs and Limited Participation in Financial Markets: Reconciling Data and Theory," Temi di discussione (Economic working papers) 620, Bank of Italy, Economic Research and International Relations Area.
  3. Bilias, Yannis & Georgarakos, Dimitris & Haliassos, Michalis, 2009. "Portfolio Inertia and Stock Market Fluctuations," CEPR Discussion Papers 7239, C.E.P.R. Discussion Papers.
  4. Pierre-André Chiappori & Monica Paiella, 2008. "Relative Risk Aversion Is Constant: Evidence from Panel Data," Discussion Papers 5_2008, D.E.S. (Department of Economic Studies), University of Naples "Parthenope", Italy.
  5. Monica Paiella & Andrea Tiseno, 2005. "Stock market optimism and participation cost: a mean-variance estimation," DNB Working Papers 040, Netherlands Central Bank, Research Department.
  6. Khorunzhina, Natalia, 2013. "Structural estimation of stock market participation costs," Journal of Economic Dynamics and Control, Elsevier, vol. 37(12), pages 2928-2942.
  7. Francisco Gomes & Alexander Michaelides & Valery Polkovnichenko, 2009. "Optimal Savings with Taxable and Tax-Deferred Accounts," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 12(4), pages 718-735, October.
  8. Ricardo M. Sousa, 2007. "Wealth Shocks and Risk Aversion," NIPE Working Papers 28/2007, NIPE - Universidade do Minho.
  9. Marco Angrisani & Michael D. Hurd & Erik Meijer, 2012. "Investment Decisions in Retirement: The Role of Subjective Expectations," Working Papers wp274, University of Michigan, Michigan Retirement Research Center.

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