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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.

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  • 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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    Cited by:

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    2. Fong, Joelle H. & Koh, Benedict S.K. & Mitchell, Olivia S. & Rohwedder, Susann, 2021. "Financial literacy and financial decision-making at older ages," Pacific-Basin Finance Journal, Elsevier, vol. 65(C).
    3. Melanie Koch & Thomas Scheiber, 2022. "Household savings in CESEE: expectations, experiences and common predictors," Focus on European Economic Integration, Oesterreichische Nationalbank (Austrian Central Bank), issue Q1/22, pages 29-54.
    4. Fong, Joelle H. & Koh, Benedict SK. & Mitchell, Olivia S. & Rohwedder, Susann, 2019. "Financial literacy and suboptimal financial decisions at older ages," CFS Working Paper Series 630, Center for Financial Studies (CFS).
    5. Xiaomeng Lu & Jingna Xiao & Yu Wu, 2021. "Financial literacy and household asset allocation: Evidence from micro‐data in China," Journal of Consumer Affairs, Wiley Blackwell, vol. 55(4), pages 1464-1488, December.

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    More about this item

    Keywords

    familiarity bias; growth; Portfolio choice; social welfare; underdiversification;
    All these keywords.

    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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