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

Households with familiarity bias tilt their portfolios towards a few risky assets. Consequently, household portfolios are underdiversified and excessively volatile. To understand the implications of underdiversification for social welfare, we solve in closed form a model of a stochastic, dynamic, general-equilibrium economy with a large number of heterogeneous firms and households, who bias their investment toward a few familiar assets. We find that the direct mean-variance loss from holding an underdiversified portfolio that is excessively risky is a modest 1.66% per annum, consistent with the estimates in Calvet, Campbell, and Sodini (2007). However, we show that in a more general model with intertemporal consumption, this loss is ampli_ed because it increases household consumption-growth volatility. Moreover, in general equilibrium where growth is endogenous, we show that the welfare losses of individual households are magnified further through the externality on aggregate investment and growth. We demonstrate that even when forcing the familiarity biases in portfolios to cancel out across households, their implications for consumption and investment choices do not cancel - individual household biases can have significant aggregate effects. Our results illustrate that financial markets are not a mere sideshow to the real economy and that financial literacy, regulation, and innovation that improve the financial decisions of households can have a significant positive impact on social welfare, equivalent to an increase in the expected return on aggregate wealth of over 10% per annum.