1 Household Finance Household Finance, JF August 2006 Down or Out: Assessing the Welfare Costs of Household Investment Mistakes, with Laurent Calvet and Paolo Sodini, JPE October 2007 Fight or Flight? Rebalancing Behavior of Individual Investors, with Calvet and Sodini, QJE February 2009 John Y. Campbell
2 Household Finance A field with much interesting research but still lacking in definition and status. How do households use financial instruments to attain their objectives? Unlike asset pricing, no special status for wealthy or risk-tolerant households.
3 Positive vs. Normative Positive household finance: How do households invest? Hard to measure. Normative household finance: How should households invest? Hard to model. Can they be different? Revealed preference. Investment mistakes.
4 Investment Mistakes Some decisions are inconsistent with a broad range of standard models, and the advice commonly given by financial planners. I will interpret these as investment mistakes. Households may make them, but can learn to avoid them.
5 Investment Mistakes Who makes them? What are the welfare costs? Does financial innovation help? How can we help?
6 Four Examples Mistake 1: Failure to participate. Mistake 2: Failure to diversify. Mistake 3: Risky share inertia. Mistake 4: Mortgage refinancing inertia.
7 Mistake 1: Failure to Participate
11 Who Participates? 2001 Survey of Consumer Finances Reference High school College Income +1σ Wealth +1σ 57% participation 15% increase 28% increase 17% increase 37% increase
12 Is This A Mistake? Fixed costs may justify nonparticipation. But the effect of education suggests that this is not just a rational response to fixed costs. We will see similar patterns in other financial decisions that are harder to explain using fixed costs.
13 Life-Cycle Patterns Life-cycle studies (Ameriks and Zeldes 2004, Fagereng, Gottlieb, and Guiso 2011) find a hump shape in participation and a declining risky share among participants with age. May be explained by some combination of Life-cycle hump in financial wealth One-time entry cost and small ongoing participation costs Increasing risk aversion with age Life-cycle hump in financial competence (Agarwal, Driscoll, Gabaix, and Laibson 2009)
17 Mistake 2: Failure to Diversify
18 The Measurement Challenge Surveys do not generally go down to the individual asset level. Brokerage account data do not show a household s complete portfolio. Calvet, Campbell, and Sodini (JPE 2007) use Swedish government data: collected because Sweden has a wealth tax. details of each citizen s portfolio at the end of each year.
19 Household M-V Analysis Historical average returns are noisy estimates of mean returns, especially in short samples. Accordingly CCS impose an asset pricing model and use it to infer mean returns. Base case: international CAPM where the hedged world index is mean-variance efficient. Alternative case: Fama-French three-factor model with market, size, and value factors. CCS assess mean-variance efficiency of the portfolios held by households at the end of 2002.
20 CCS Scatter Plots of Household Portfolios Household Stock Portfolios World Index in USD World Index in SEK Swedish Index in SEK Swedish T-Bill Stock Portfolios Return Mean Return Standard Deviation
21 Complete Portfolios Household Complete Portfolios World Index in USD World Index in SEK Swedish Index in SEK Swedish T-Bill Return Mean Return Standard Deviation
22 Measuring Diversification Household Sharpe ratio S h h h Relative Sharpe ratio loss wrt benchmark S B RSRL h 1 S S h B Return loss (vertical distance to the efficient frontier) RL h S B h h
23 Return Loss Median return loss is 1.17% ($131 per year) relative to hedged world index and only 0.30% ($33) relative to unhedged world index. These numbers are modest even though median share of idiosyncratic variance in total variance is quite large at 56%. At the 95 th percentile, return losses are much larger: 5.04% ($2,204) and 2.65% ($851).
24 Who Incurs Return Loss? Financially sophisticated households (rich, educated, with complementary financial markets experience) invest efficiently but take more risk. Retired and unemployed households invest inefficiently and take less risk. Entrepreneurs and larger households invest conservatively. Overall, financially sophisticated nonentrepreneurial households have the greatest return losses. Consistent with the idea that people know their limitations.
25 Efficient benchmark Return mean Sophisticated and aggressive Large return loss Unsophisticated and cautious Small return loss Return standard deviation
26 Conclusions of JPE Paper Many Swedish households are well diversified, but there is significant cross-sectional variation in household portfolio returns Mutual funds play a vital role in diversification. A minority of households are undiversified. Financial sophistication improves portfolio efficiency but also increases risk-taking. The welfare cost of nonparticipation is smaller when we consider that nonparticipants would be likely to invest cautiously and inefficiently.
27 Missing Fees CCS analysis ignores mutual fund fees Treats mutual funds as if they obey the CAPM, like individual stocks Results are fairly similar assuming a flat fee across all funds except the top ten, for which fees are directly measured But it would be very interesting to see if less sophisticated households pay higher fees French (2008) documents high and stable overall cost of active asset management
28 French, The Cost of Active Investing, JF 2008
29 Mistake 3: Risky Share Inertia
30 Basic Facts High stock returns 1999, then bear market Household participation rate increased in 2000, then fell only very slightly But the share of risky assets in the portfolios of participating households declined substantially Our estimate of portfolio standard deviation moves closely with the risky share, so we focus on the risky share as a convenient summary measure of risktaking At first we look only at continuing participants
32 What Drives the Risky Share? Why did the aggregate risky share decline? Inertia A decline in the desired risky share We cannot tell using aggregate data Small aggregate flows are consistent with either explanation In closed-economy general equilibrium, desired and actual risky share must coincide We use cross-sectional variation to get extra information Variation in the initial risky share Variation in portfolios and thus in realized returns
33 Passive Risky Share Our dataset gives us the unique ability to calculate the passive share, the risky share that will result from risky asset returns if a household trades no assets. The passive share is U-shaped in initial risky share if risky returns are negative, and humpshaped if they are positive. Portfolio inertia implies that a household s actual risky share will closely track its passive share.
34 Passive Risky Share
35 Active and Passive Shares
36 Figure 3
37 Figure 3
38 Rebalancing and Mean-Reversion These figures suggest that households rebalance (active hump shape offsetting passive U shape). They also suggest mean-reversion in portfolio share (downward slope in active change). But there is limited information in the data aggregated this way.
39 Identifying Rebalancing Because households are imperfectly diversified, their risky portfolio returns vary cross-sectionally. Our earlier paper found a 56% median share of idiosyncratic variance in total variance. This enables us to estimate rebalancing propensity more precisely. Overall, rebalancing offsets more than half the passive variation in the risky share. More sophisticated households have a stronger tendency to rebalance.
40 Figure 2
41 Figure 2
43 A Partial Adjustment Model Target share Passive share Adjustment speed Change in the target
44 An Econometric Problem To handle household fixed effects in the target risky share, one must difference the model The error term in the regression is then MA(1) and correlated with the change in the passive risky share. A positive shock between t-1 and t raises the risky share at t, which influences the passive share at t+1. Solution: create an instrument for the change in the passive share that removes this effect.
45 An Instrument The zero-rebalancing passive change at t+1 is the passive change that would be observed if the household did not rebalance at t. Because rebalancing is limited, this is correlated with the actual passive change. But it is uncorrelated with the MA(1) error term in the regression.
47 Who Rebalances? Financially sophisticated households (with greater wealth, income, and education) rebalance faster Wealthy households have a target share that declines less in the bear market An increase in financial wealth increases the target share Suggests DRRA, could result from habit formation Effect depends on IV, but controls for inertia Compare with Brunnermeier-Nagel (AER 2007)
48 Trading Individual Assets The Swedish data also show evidence of the disposition effect (Shefrin and Statman 1985, Odean 1998) A stock (but not a mutual fund) is more likely to be fully sold if it has done well Wealthy households with high risky shares and well diversified portfolios of individual stocks are less likely to display this pattern The pattern does not show up in partial sales, which instead seem to be rebalancing trades.
49 Mistake 4: Mortgage Refinancing Inertia
50 The US Mortgage Market The mortgage is the largest financial contract for a typical household. In the US, nominal fixed-rate mortgages predominate. These mortgages carry a valuable option to refinance. In the past, some households have refinanced slowly and have paid high rates on old mortgages.
52 Who Refinances? American Housing Survey Reference 28% High school College Income +1σ Home val. +1σ Age +1σ 5% increase 9% increase 1% increase 7% increase 4% decrease
53 Who Moves? American Housing Survey Reference High school College Income +1σ Home val. +1σ Age +1σ 5% confirmed 4% increase 5% increase 1% increase 0% decrease 2% decrease
54 Who Misstates Their Rate? American Housing Survey 2001 Reference 1.3% High school College Income +1σ Home val. +1σ Age +1σ 0.6% decrease 0.5% decrease 0.3% decrease 0.1% increase 0.1% decrease
55 Mortgages in the Credit Boom During the credit boom, there was financial innovation in the subprime lending market. People with poor credit took out adjustable-rate mortgages (ARMs) with low initial rates and large potential for upside adjustments. ARMs could only be refinanced with rising house prices. House price declines and upward rate adjustments have driven up defaults and foreclosures. Did people understand the risks of these ARMs?
56 Equilibrium Household Finance
57 Equilibrium Household Finance Household investment problems are inherently complex. Often, contracts do not make them easier. It may not be surprising that households make investment mistakes. But why don t easier-to-manage contracts evolve?
58 Barriers to Financial Innovation General barriers: Costs of reaching households. Lack of effective patent protection. Specific barrier to simplifying innovation: Complex products create cross-subsidy from naïve to sophisticated households. Example: mortgage refinancing option.
59 Cross-Subsidy and Equilibrium Cross-subsidy permits shrouded equilibrium (Gabaix and Laibson, QJE 2006). Naïve households do not adopt a new product because they do not understand it. Sophisticated households lose cross-subsidy if they switch to the new product. Innovators do not gain by educating households. How important is cross-subsidy in practice?
60 Cross-Subsidy in Mortgages In the US, fixed mortgage rates have been lower because of sluggish refinancing: Total payments made in AHS exceeding current rate + 1%: 53bp in 1997, 43 bp in 1999, 66bp in 2001, and 107bp in This inhibits the development of automatically refinancing or inflation-adjusted mortgages.
61 Cross-Subsidy in Mortgages Miles Report on UK mortgage finance UK adjustable mortgages offer low teaser rate (roughly LIBOR). high standard rate (LIBOR + 175bp). no refinancing penalty. This is possible only because of sluggish refinancing almost 1/3 of borrowers paid standard rate in It inhibits the use of fixed-rate mortgages.
63 Investment Mistakes Who makes them? Poorer and less educated households. What are the welfare costs? Modest for many, substantial for some. Interactions across mistakes.
64 Investment Mistakes Does financial innovation help? Often proceeds slowly in retail markets. The problem of cross-subsidy. The problem of innovation to exploit confusion. IT allows cheap customization. How can we help? Basic financial literacy. Disclosures, default options, and product design: household financial engineering.
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