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

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  • Bhamra, Harjoat Singh
  • Uppal, Raman

Abstract

Households with familiarity biases tilt their portfolios toward a few risky assets. Consequently, household portfolios are underdiversified and excessively volatile. To understand the implications of underdiversification for social welfare, we solve in closed form a model of a stochastic, dynamic, general-equilibrium economy with a large number of heterogeneous firms and households that bias their investments toward a few familiar assets. We find that the direct mean-variance loss from holding an underdiversified portfolio that is excessively risky is equivalent to a reduction of 1.66% per annum in a household's portfolio return, consistent with the estimate in Calvet, Campbell, and Sodini(2007). However, we show that in a more general model with intertemporal consumption, underdiversified portfolios increase consumption-growth volatility, amplifying the mean-variance losses by a factor of four. Moreover, in general equilibrium where growth is endogenous, underdiversified portfolios distort also aggregate investment and growth even when familiarity biases in portfolios cancel out across households. We find that the overall social welfare loss is about six times as large as the direct mean-variance loss. Our results illustrate that financial markets are not a mere sideshow to the real economy and that financial literacy, regulation, and innovation that improve the financial decisions of households can have a significant positive impact on social welfare.

Suggested Citation

  • Bhamra, Harjoat Singh & Uppal, Raman, 2017. "Does Household Finance Matter? Small Financial Errors with Large Social Costs," CEPR Discussion Papers 12414, C.E.P.R. Discussion Papers.
  • Handle: RePEc:cpr:ceprdp:12414
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    References listed on IDEAS

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    1. 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.
    2. Back, Kerry, 2010. "Asset Pricing and Portfolio Choice Theory," OUP Catalogue, Oxford University Press, number 9780195380613.
    3. 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.
    4. 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.
    5. Shlomo Benartzi & Richard Thaler, 2004. "Save more tomorrow: Using behavioral economics to increase employee saving," Natural Field Experiments 00337, The Field Experiments Website.
    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.
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    More about this item

    Keywords

    familiarity bias; growth; Portfolio choice; social welfare; underdiversification;

    JEL classification:

    • E03 - Macroeconomics and Monetary Economics - - General - - - Behavioral Macroeconomics
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • G02 - Financial Economics - - General - - - Behavioral Finance: Underlying Principles
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions

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