Do Financial Mistakes by Households Matter for Society?
Diversiﬁcation is the only free lunch in investing (Markowitz, 1952). Institutional investors understand very well that we should not put all our eggs in one basket. But households don’t seem to understand this at all: empirical evidence shows that most households invest in only a handful of stocks, with the median number of stocks held being three. Typically, households invest disproportionately in companies with which they are familiar or those that operate locally. An extreme example of ignoring the beneﬁts of diversiﬁcation is investing in the stock of the company by which one is employed, tying one's entire fate to the fortunes of one's employer. For instance, almost two-thirds of Enron employees’ retirement assets were invested in Enron itself and between January 2001 and January 2002, the value of Enron stock fell by over 99%. Enron is not a special case: ﬁve million Americans have over 60% of their retirement savings invested in own-company stock and only 33% of these households realize that it is riskier than a diversiﬁed fund with many diﬀerent stocks (Benartzi, Thaler, Utkus, and Sunstein, 2007).
In a recent paper, Bhamra and Uppal (2019), which is titled “Does Household Finance Matter? Small Financial Errors with Large Social Costs,” we examine the consequences of household decisions to invest in poorly diversiﬁed portfolios. That investing in underdiversiﬁed portfolios leads households to bear more ﬁnancial risk than is optimal is obvious. However, Calvet, Campbell, and Sodini (2007) ﬁnd, based on administrative data for Swedish households, that the direct welfare costs to individual households from underdiversiﬁed portfolios are equivalent to a modest reduction of about 1% per year in a portfolio return.
In our paper, we examine the welfare losses from underdiversiﬁcation in a richer framework that allows underdiversiﬁcation to impact also asset allocation (that is, the share of wealth to allocate to risky assets and the share to the safe asset), consumption (that is, how much to withdraw from one's portfolio to fund consumption at each date over a household’s lifetime), and aggregate growth for the economy. The advantage of this framework is that it provides additional channels through which underdiversiﬁcation can lead to welfare losses for individual households and also the overall economy.
In the framework we consider, the production decisions of ﬁrms are endogenous. We also model households so that they exhibit familiarity biases, which leads households to concentrate investments in a few familiar ﬁrms rather than holding a portfolio that is well diversiﬁed across all ﬁrms. Importantly, we specify that familiarity biases cancel out across households implying that our results are not a consequence of aggregate familiarity biases
Because of the familiarity-induced tilt in portfolios, each household’s portfolio return is excessively risky relative to the return of the optimally diversiﬁed portfolio. This excessively risky portfolio is the ﬁrst source of welfare loss for the household. The excessively risky portfolio has knock-on eﬀects on the household’s allocation decision: because of its excessively risky portfolio, the household reduces the investment in risky assets and instead increases allocation into the safe asset. The misallocation across risky and safe assets decreases the expected return on the household’s investment, which is the second source of welfare loss. The reduction in expected return on each household’s investment distorts also its consumption-saving decision, which is the third source of welfare loss. Upon aggregation across all the households in the economy, the biased consumption-saving decisions of individual households add up to distort the aggregate growth rate and also reduce social welfare.
Our work delivers two key insights. First, even though the welfare loss to a household from investing in an underdiversiﬁed portfolio is modest, once we incorporate the eﬀect of familiarity biases on the household’s decision to allocate wealth between risky and safe assets and on its consumption-savings decision, the welfare loss to the household is ampliﬁed by a factor of four. Second, even if one were to force the familiarity biases in portfolios to cancel out across households, their implications for consumption and investment choices would not cancel. This is because holding a portfolio that is excessively risky leads all households to distort their consumption-savings decision by reducing how much they save. Consequently, household-level distortions to individual consumption upon aggregation have a substantial eﬀect on aggregate growth and social welfare.
Overall, combining the impact of underdiversiﬁcation on intertemporal consumption and aggregate growth ampliﬁes social welfare losses by ﬁve to six times that of the direct losses from underdiversiﬁcation. These potential gains are equivalent to an increase in the return on aggregate wealth of about 5% per year. Most of this gain arises from a multiplier eﬀect applied to the gains for a household with utility deﬁned over risk and expected return (mean-variance utility). This multiplier eﬀect is driven by the impact of improved portfolio diversiﬁcation on consumption smoothing over time at the microeconomic level and on aggregate growth at the macroeconomic level.
These insights suggest that the impact on household and social welfare of ﬁnancial policies through innovation, education, and regulation can be substantial. In fact, one could say that eﬀecting this change at a household level could have an eﬀect on economic growth that was of similar magnitude to what can be achieved through monetary and ﬁscal policy. Therefore, there is strong motivation to think seriously about how we can get households to diversify their investments. Several options exist, which we beleive could work, wether individually or in combination.
One such policy measure would be to “nudge” households toward default portfolios that are well diversiﬁed (Thaler and Sunstein, 2003). For instance, households could be oﬀered a small number of portfolios to choose from, with the portfolios having diﬀerent levels of risk, but all of them being well diversiﬁed. A good example of this approach is Sweden, where the default social security plan is diversiﬁed internationally.
Improving ﬁnancial literacy is another solution. In an ideal world, this would happen at high school, but as we do not live in such a world, we could look at good sense marketing campaigns or employer-led programmes instead. For example, households could be educated about the beneﬁts of diversiﬁcation that result from investing in broadly diversiﬁed funds, such as mutual funds and ETFs.
A third measure would be to introduce ﬁnancial regulation to curtail the tendency of households to bias portfolios toward a few familiar assets. For example, ﬁnancial regulation could be introduced to prohibit companies from providing employees own-company stock when matching the pension contributions of employees. It could also be through a simpliﬁcation of investment procedures into mutual funds.
The ﬁnancial-services sector can play an important role in helping to design products that make it easier for households to diversify their investments and to improve access to those that exist. What our work shows is that, in addition to the direct beneﬁts of diversiﬁcation to each household, there are substantial indirect beneﬁts both for individual households and for the aggregate economy. Therefore, encouraging households to hold better-diversiﬁed portfolios would not only beneﬁt households but also boost overall economic growth.