Working Paper Series

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

Households with familiarity biases tilt their portfolios toward a few risky assets. The resulting mean-variance loss from portfolio underdiversification is equivalent to only a modest reduction of ...

Author(s) :

Harjoat S. Bhamra

Abstract :

Households with familiarity biases tilt their portfolios toward a few risky assets. The resulting mean-variance loss from portfolio underdiversification is equivalent to only a modest reduction of about 1% per year in a household’s portfolio return. However, once we consider also the effect of familiarity biases on the asset-allocation and intertemporal consumption-savings decisions, the welfare loss is multiplied by a factor of four. In general equilibrium, the suboptimal decisions of households distort also aggregate growth, amplifying further the overall social welfare loss. Our findings demonstrate that financial markets are not a mere sideshow to the real economy and that improving the financial decisions of households can lead to large benefits, not just for individual households, but also for society.

Keywords: Portfolio choice, underdiversification bias, growth, social welfare

Link SSRN

Date : 17/09/2018
Working Paper Number: WP-18-004

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