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

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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@inproceedings{Bhamra2014DoesHF, title={Does Household Finance Matter? Small Financial Errors with Large Social Costs∗}, author={Harjoat S. Bhamra and Raman Uppal and Brad M. Barber and Giuseppe Bertola and Sebastien Betermier and Jaroslav Borovi{\vc}ka and Andrea Buraschi and Laurent E. Calvet and John Y . Campbell and Bruce Ian Carlin and Georgy Chabakauri and J Faridy Cocco and M. Max Croce and Bernard Dumas and Jack Favilukis and Ren{\'e} Garcia and Naveen Khanna and Samuli Kn{\"{u}pfer and Kai Li and Abraham Lioui and Florencio Lopez De Silanes and Hanno Lustig and Robert Marquez and Alex A Michaelides and Anna Pavlova and Kim Peijnenburg and Tarun Ramadorai and Paolo Sodini}, year={2014} }