Down or Out: Assessing the Welfare Costs of Household Investment Mistakes

Abstract

This paper investigates the efficiency of household investment decisions in a unique dataset containing the disaggregated wealth and income of the entire population of Sweden. The analysis focuses on two main sources of inefficiency in the financial portfolio: underdiversification of risky assets ("down") and nonparticipation in risky asset markets ("out"). We find that while a few households are very poorly diversified, the cost of diversification mistakes is quite modest for most of the population. For instance, a majority of participating Swedish households are sufficiently diversified internationally to outperform the Sharpe ratio of their domestic stock market. We document that households with greater financial sophistication tend to invest more efficiently but also more aggressively, so the welfare cost of portfolio inefficiency tends to be greater for these households. The welfare cost of nonparticipation is smaller by almost one half when we take account of the fact that nonparticipants would be unlikely to invest efficiently if they participated in risky asset markets.

Financial literacy, financial advice, and financial behavior

“…4.1), several contributions lacking an observable measure of financial capabilities exploit this evidence and use respondents' demographics in order to capture their financial literacy. Corresponding proxies for financial sophistication used in the literature include (disposable) income and wealth (Dhar and Zhu 2006;Vissing-Jorgensen 2003;Calvet et al 2007Calvet et al , 2009) as well as age (Calvet et al 2007(Calvet et al , 2009Georgarakos and Pasini 2011), educational attainment (Christiansen et al 2008;Calvet et al 2007Calvet et al , 2009), professional status (Calvet et al 2009), and even IQ (Grinblatt et al 2011(Grinblatt et al , 2012. Likewise, both Chalmers and Reuter (2012) and Hackethal et al (2012) use subsets of these demographics to proxy for financial literacy in their analyses.…”

Financial Literacy and Planning: Implications for Retirement Wellbeing

“…Others have offered evidence on related topics; for instance Calvert, Campbell, and Sodini (2007) show that more sophisticated households are more likely to buy equities and invest more efficiently, 1 and Hilgerth, Hogarth, and Beverly (2003) and Lusardi and Mitchell (2009) demonstrate strong links between financial knowledge and financial behavior. Our contribution reports on a special module on planning and financial literacy we designed for the 2004 Health and Retirement Study (HRS) which allows us to investigate how workers make their saving decisions, how they collect the information for making these decisions, and whether they possess the financial literacy needed to make these decisions.…”

Financial Literacy and Savings Account Returns

“…For an overview, see Campbell (2006) and Guiso and Sodini (2013). Moreover, several studies have documented how investment mistakes correlate with proxies for financial knowledge such as education (e.g., Calvet et al 2007;Bilias et al 2010). demographic characteristics, asset and debt holdings, housing, work, health and income, as well as economic and psychological concepts. Variables used from the survey are reported below.…”