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Does Household Finance Matter? Small Financial Errors with Large Social Costs

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  • Harjoat S. Bhamra
  • Raman Uppal

Abstract

Households with familiarity biases tilt their portfolios toward a few risky assets. The resulting mean-variance loss from portfolio underdiversification is equivalent to only a modest reduction of about 1 percent per year in a household's portfolio return. However, once we consider also the effect of familiarity biases on the asset-allocation and intertemporal consumption-savings decisions, the welfare loss is multiplied by a factor of four. In general equilibrium, the suboptimal decisions of households distort also aggregate growth, amplifying further the overall social welfare loss. Our findings demonstrate that financial markets are not a mere sideshow to the real economy and that improving the financial decisions of households can lead to large benefits, not just for individual households, but also for society.

Suggested Citation

  • Harjoat S. Bhamra & Raman Uppal, 2019. "Does Household Finance Matter? Small Financial Errors with Large Social Costs," American Economic Review, American Economic Association, vol. 109(3), pages 1116-1154, March.
  • Handle: RePEc:aea:aecrev:v:109:y:2019:i:3:p:1116-54
    Note: DOI: 10.1257/aer.20161076
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    References listed on IDEAS

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    1. Nataliya Barasinska & Dorothea Schäfer & Andreas Stephan, 2008. "Financial Risk Aversion and Household Asset Diversification," Discussion Papers of DIW Berlin 807, DIW Berlin, German Institute for Economic Research.
    2. Robert Ready & Mariano Croce & Federico Gavazzoni & Riccardo Colacito, 2016. "Currency Risk Factors in a Recursive Multi-Country Economy," 2016 Meeting Papers 297, Society for Economic Dynamics.
    3. Constantinides, George M & Duffie, Darrell, 1996. "Asset Pricing with Heterogeneous Consumers," Journal of Political Economy, University of Chicago Press, vol. 104(2), pages 219-240, April.
    4. Back, Kerry, 2010. "Asset Pricing and Portfolio Choice Theory," OUP Catalogue, Oxford University Press, number 9780195380613.
    5. Richard H. Thaler & Shlomo Benartzi, 2004. "Save More Tomorrow (TM): Using Behavioral Economics to Increase Employee Saving," Journal of Political Economy, University of Chicago Press, vol. 112(S1), pages 164-187, February.
    6. Epstein, Larry G & Zin, Stanley E, 1989. "Substitution, Risk Aversion, and the Temporal Behavior of Consumption and Asset Returns: A Theoretical Framework," Econometrica, Econometric Society, vol. 57(4), pages 937-969, July.
    Full references (including those not matched with items on IDEAS)

    More about this item

    JEL classification:

    • D14 - Microeconomics - - Household Behavior - - - Household Saving; Personal Finance
    • D91 - Microeconomics - - Micro-Based Behavioral Economics - - - Role and Effects of Psychological, Emotional, Social, and Cognitive Factors on Decision Making
    • E21 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Consumption; Saving; Wealth
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G41 - Financial Economics - - Behavioral Finance - - - Role and Effects of Psychological, Emotional, Social, and Cognitive Factors on Decision Making in Financial Markets

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