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Down or Out: Assessing the Welfare Costs (...)

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

This paper, by Laurent E. Calvet, John Y. Campbell and Paolo Sodini, studies the effectiveness of the Swedish
household population’s investment strategies and analyses the main causes of inefficiency –
underdiversification (down) and nonparticipation in risky asset markets (out). The Swedish data records are, thus, utilized
to determine the individual financial assets of all households, accounted by financial institutions and verified by
taxpayers.

Following the assessment of the means of Swedish household portfolio returns, four results were obtained. First, in many
household portfolios, direct stockholdings are dominated by mutual funds and cash, thereby restricting the loss returns
from concentrated stock portfolios. Second, a minor part of Swedish households seem to be exceedingly
underdiversified. Third, sophisticated Swedish households are likely to invest efficiently and aggressively, in so doing,
increasing the return loss from the portfolio inefficiency of these households. Fourth, nonparticipating households are
predisposed to invest poorly in risky asset markets.

Household Asset Allocation

1. Data Summary: The authors have provided a concise interpretation of the Swedish economy and tax system
2. Aggregate Asset Allocation: The aggregate gross wealth of households is estimated by calculating the value of
financial and real estate assets held by the household
3. Asset Allocation in Cross-Section: Following the investment patterns of households, it has been observed that mutual
funds play a vital role in household diversification. In addition, average financial wealth is significantly higher for
participating households than nonparticipating households

Diversification of Household Portfolios

1. Idiosyncratic and Systematic Risk: The authors analyze the asset returns and characteristics of household portfolios
2. Contributors to Idiosyncratic Risk: The assessment of idiosyncratic volatility of household risky portfolios is done
3. Estimating the Mean Returns of Household Portfolios: The global Capital Asset Pricing Model (CAPM) is used for the
analysis of international diversification
4. Mean-Variance Measure of Diversification:
o Relative Sharpe Ratio Loss: The authors calculate diversification losses by comparing the Sharpe ratio of a household
portfolio with the benchmark index
o Return Loss: The inefficiency of household portfolio is discussed by computing the return losses for households’
risky and complete portfolios
o Connecting the Dots: Summary of the previous results

Who is Underdiversified?
It has been discerned that characteristics of households determine the characteristics of the portfolios they hold.
Households with financial sophistication invest in risky assets and prefer diversified portfolios, thus bearing higher return
losses. Conversely, less sophisticated households such as entrepreneurs, retirees and unemployed dummies, owing to
their restricted investment skills, invest in lower risky shares and endure fairly lower return losses.
1. Robustness Checks: Tax optimization strategies lead to inefficiency in some household portfolios
Down or Out?
1. Who Participates in Risky Asset Markets?: The analysis of active participants in risky asset markets is carried out
2. The Welfare Cost of Nonparticipation: The authors estimate the return lost by a nonparticipating household
Conclusion
Many Swedish households are efficiently diversified. These households achieve international diversification through the
equity and balanced mutual funds sold by the domestic markets.

Reference

Calvet, Laurent E., Campbell, John Y. and Sodini, Paolo, "Down or Out: Assessing the Welfare Costs of Household
Investment Mistakes" (February 2006). Harvard Institute of Economic Research Discussion Paper No. 2107 Available at
SSRN: http://ssrn.com/abstract=881768

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