Life-cycle Portfolio Choice: the Role of Heterogeneous Under-diversification
The standard life-cycle portfolio choice model assumes that all agents invest in a diversified stock market index. In contrast recent empirical evidence, summarized in Campbell (2006) suggests that households' financial portfolios are under-diversified and that there is substantial heterogeneity in diversification. In the present paper I examine the effects of heterogeneous under-diversification in a life-cycle portfolio choice model with fixed per period participation costs and progressive social security. Progressive social security has a minor negative effect on participation rates and creates a negative relationship between stock share and permanent income/education. Realistically calibrated under-diversification generates moderate participation rates and conditional stock shares that are comparable with the empirical evidence. Moreover when it is negatively related to wealth or education it restores the positive relationship between income/education and equity shares found in the data.
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