This post is the first part of a two-part series on the learnings and takeaways from a rigorous course series on Household Finance at Knut Wicksell Centre of Financial Studies, Lund University, Sweden.
At Dvara Research, the Household Finance Initiative aims to analyse the financial and non-financial strategies deployed by households to achieve their goals as well as identify the financial mistakes arising from sub-optimal portfolio allocation. The initiative also informs product design and policies to minimize or mitigate the adverse effects of these mistakes on vulnerable low-income households.
As a policy-relevant academic field, Household Finance was considered as a self-standing, relevant discipline from 2006. Traditionally, financial research related to consumers and households were studied through the discipline of asset pricing or corporate finance because household asset demands contributed to determining prices. It was only in 2006 that Campbell in a seminal piece of work asked the question – how do households use financial instruments to attain their objectives? This triggered substantial curiosity and interest among researchers and departments across continents and led to the creation of household finance as a subfield of finance. Soon after researchers realized that the total value of assets and liabilities held by US households was $72 trillion and $14 trillion, much larger than the total value of assets and liabilities held by corporations (approx. assets worth $28 trillion and liabilities worth $13 trillion). This pushed academic institutions to acknowledge the scale and characteristics of household finance as an independent academic field.
Through the course, Household Finance was broadly referred to as the study of how households manage means of payment, forms of debt, insurance contracts and interact with financial intermediaries. The related literature closely examined financial and physical asset building, portfolio behaviour, borrowing decisions and investment choices for households at both macro and micro levels. In addition to this, the discipline also acknowledged that households must manage human capital that is slow-growing, hard to predict, non-tradeable and bears idiosyncratic and uninsurable risks. Recent additions to the theory attempted to decode the behavioural underpinnings for financial decisions and acknowledged the ways in which households diverge from normative models of portfolio balancing with a significant emphasis on mistakes committed by households. Academically, theoretical conceptual models and empirical models of household finance are built to explain households’ financial decisions and simultaneously analysing the influence of public and private choices on the households.
One of the limitations of this growing field has been its predisposition towards generating evidence from developed countries where households do not particularly endure access barriers to sophisticated financial instruments and services. There are certain barriers related to information and behavioural biases but the underlying assumption from a developed country context is near complete geographical or digital access to financial services.
In this post, we will begin by discussing the different streams of literature on empirical household finance. Two major strands of academic literature that we will discuss are the participation of households in financial markets and allocation of financial resources and risk preference reflected through financial portfolio choices of households.
Empirical Literature on financial market participation and asset allocation of households
Literature related to participation and allocation of financial resources assesses households’ portfolios across multiple parameters like age, wealth levels (physical and financial assets), financial instruments and other socio-economic characteristics. In the US and European market context (broadly identified as developed countries), Household Finance literature ranges from decoding the households’ balance sheet, understanding risk preferences of investors and scientifically evaluating the effect of demographics, wealth, biological design and behaviour on the financial portfolio. For instance, Guiso and Sodini (2013) have extensively studied the distribution (participation and allocation) of tangible wealth in the cross-section of households. Using the triennial database of Survey of Consumer Finance (SCF) in the US, the study plots the composition of wealth across deciles of wealth classes. The results show that among US consumers, real assets[i] form a bulk of household wealth across all wealth class deciles, except in the lowest income class.
Studies show that in developed countries, participation in the financial market is limited to households below median wealth level and monotonically increases with the level of wealth for all asset classes (Guiso and Sodini, 2013). The literature posits four puzzles related to asset allocation – stock market non-participation, under-diversification, poor trading performance and investment in actively managed and costly mutual funds. Each puzzle has underpinning explanations in behavioural and theoretical literature for investors in developed and developing countries. For instance, literature documents that the composition of risky investment varies widely across investors and does not agree with the classical frictionless portfolio models that predicts homogeneity of investor behaviour across all asset classes (Canner, Mankiw and Weil, 1994).
At a macro level, an important paper by Badarinza, Campbell and Ramodorai (2016) provide a systematic comparison of household balance sheets across 13 developed countries comparing the international evidence. This gives an excellent insight into the nature of asset allocation across countries. For instance, in all the surveyed countries households have the highest participation in bank deposit and transaction accounts followed by retirement asset held in defined-contribution pension plans. However, there is considerable variation across countries in participation rates for directly held stocks and mutual funds. A dominant and common non-financial asset across all 13 countries is the household’s primary residential property. On the liabilities side, 75% of households in the US are indebted whereas only 25% of Italians had any debt.
Impact of risk preference on household asset allocation
Another important aspect of Household Finance which determines the extent of participation in the financial market is the consumer’s risk preference. Measurement of risk preference is central to financial portfolio choice theories and are built on the standard expected utility framework of Von Neuman and Morgenstern. In classical models, there is a direct relationship between the fraction of wealth invested in risky asset and risk preference. Merton (1969) framework model for measuring risk predicts that all heterogeneity in observed portfolio shares should be explained by differences in risk attitudes, captured by the relative risk aversion parameter. That is if investors display decreasing relative risk aversion (DRRA), wealthy investors should invest a large fraction of their wealth in risky assets. In the recent literature, Guiso and Sodini have tried to test the Revealed Risk Preference by using US Survey of Consumer Finance (2007) and Swedish Wealth Registry (2007) and have found similar relative risk aversion parameters for both the countries. Some of the other methodologies to measure risk aversion taught in the course were insights collected through qualitative surveys, laboratory and field experiments.
In the next post, we will continue to discuss household finance literature on determinants of risk preference among households and how this discipline can be adapted for developing countries.
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References
- Badarinza, C., Campbell, J. Y., & Ramadorai, T. (2016). International comparative household finance. Annual Review of Economics
- Campbell, J. Y. (2006). Household finance. The Journal of Finance
- Canner, N., Mankiw, N. G., & Weil, D. N. (1994). An asset allocation puzzle. National Bureau of Economic Research
- Guiso, L., & Sodini, P. (2013). Household finance: An emerging field. In Handbook of the Economics of Finance
- Merton, R. C. (1969). Lifetime portfolio selection under uncertainty: The continuous-time case. The Review of Economics and Statistics
- Morgenstern, O., & Von Neumann, J. (1953). Theory of games and economic behaviour. Princeton University Press.
[i]Real Assets includes real estate, durable goods, valuables, and private business wealth.
