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The Foregone Gains of Incomplete Portfolios

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Listed author(s):
  • 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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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
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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Find related papers by JEL classification:
  • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
  • D12 - Microeconomics - - Household Behavior - - - Consumer Economics: Empirical Analysis
  • E21 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Consumption; Saving; Wealth

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  1. Mehra, Rajnish & Prescott, Edward C., 1985. "The equity premium: A puzzle," Journal of Monetary Economics, Elsevier, vol. 15(2), pages 145-161, March.
  2. Orazio P. Attanasio & James Banks & Sarah Tanner, 2002. "Asset Holding and Consumption Volatility," Journal of Political Economy, University of Chicago Press, vol. 110(4), pages 771-792, August.
  3. 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.
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  5. 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.
  6. 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 1121-1157, December.
  7. Monica Paiella, 2001. "Limited financial market participation: a transaction cost-based explanation," IFS Working Papers W01/06, Institute for Fiscal Studies.
  8. 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.
  9. Cochrane, John H, 1989. "The Sensitivity of Tests of the Intertemporal Allocation of Consumption to Near-Rational Alternatives," American Economic Review, American Economic Association, vol. 79(3), pages 319-337, June.
  10. Annette Vissing-Jorgensen, 2002. "Limited Asset Market Participation and the Elasticity of Intertemporal Substitution," NBER Working Papers 8896, National Bureau of Economic Research, Inc.
  11. Keim, Donald B. & Stambaugh, Robert F., 1986. "Predicting returns in the stock and bond markets," Journal of Financial Economics, Elsevier, vol. 17(2), pages 357-390, December.
  12. 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.
  13. Paul A. Samuelson, 2011. "Lifetime Portfolio Selection by Dynamic Stochastic Programming," World Scientific Book Chapters,in: THE KELLY CAPITAL GROWTH INVESTMENT CRITERION THEORY and PRACTICE, chapter 31, pages 465-472 World Scientific Publishing Co. Pte. Ltd..
  14. 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.
  15. Newey, Whitney & West, Kenneth, 2014. "A simple, positive semi-definite, heteroscedasticity and autocorrelation consistent covariance matrix," Applied Econometrics, Publishing House "SINERGIA PRESS", vol. 33(1), pages 125-132.
  16. 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 247-257, August.
  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. 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.
  19. 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.
  20. Constantinides, George M, 1982. "Intertemporal Asset Pricing with Heterogeneous Consumers and without Demand Aggregation," The Journal of Business, University of Chicago Press, vol. 55(2), pages 253-267, April.
  21. Hansen, Lars Peter & Singleton, Kenneth J, 1982. "Generalized Instrumental Variables Estimation of Nonlinear Rational Expectations Models," Econometrica, Econometric Society, vol. 50(5), pages 1269-1286, September.
  22. Annette Vissing-Jorgensen, 2002. "Limited Asset Market Participation and the Elasticity of Intertemporal Substitution," Journal of Political Economy, University of Chicago Press, vol. 110(4), pages 825-853, August.
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Cited by:

  1. Orazio P. Attanasio & Monica Paiella, 2011. "Intertemporal consumption choices, transaction costs and limited participation in financial markets: reconciling data and theory," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 26(2), pages 322-343, March.
  2. Monica Paiella & Andrea Tiseno, 2004. "Stock market optimism and participation cost: a mean-variance estimation," Econometric Society 2004 Latin American Meetings 239, Econometric Society.
  3. Khorunzhina, Natalia, 2013. "Structural estimation of stock market participation costs," Journal of Economic Dynamics and Control, Elsevier, vol. 37(12), pages 2928-2942.
  4. Guiso, Luigi & Sodini, Paolo, 2013. "Household Finance: An Emerging Field," Handbook of the Economics of Finance, Elsevier.
  5. Yannis Bilias & Dimitris Georgarakos & Michael Haliassos, 2010. "Portfolio Inertia and Stock Market Fluctuations," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 42(4), pages 715-742, 06.
  6. Paya, Ivan & Wang, Peng, 2016. "Wealth fluctuations and investment in risky assets: The UK micro evidence on households asset allocation," Journal of Empirical Finance, Elsevier, vol. 38(PA), pages 221-235.
  7. Sauro Mocetti, 2012. "Educational choices and the selection process: before and after compulsory schooling," Education Economics, Taylor & Francis Journals, vol. 20(2), pages 189-209, February.
  8. Ricardo M. Sousa, 2007. "Wealth Shocks and Risk Aversion," NIPE Working Papers 28/2007, NIPE - Universidade do Minho.
  9. Eduardo Corso, 2015. "Ambiguity and portfolio decisions," BCRA Working Paper Series 201567, Central Bank of Argentina, Economic Research Department.
  10. Pierre‐André Chiappori & Monica Paiella, 2011. "Relative Risk Aversion Is Constant: Evidence From Panel Data," Journal of the European Economic Association, European Economic Association, vol. 9(6), pages 1021-1052, December.
  11. Xiong, Qizhou, 2015. "Censored Fractional Response Model: Estimating Heterogeneous Relative Risk Aversion of European Households," IWH Discussion Papers 11/2015, Halle Institute for Economic Research (IWH).
  12. 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.
  13. 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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