Week 8- Household Finances 2

Question 1

What are the 3 puzzles of household finance which Campbell (2006) observes?

Answer 1

• Failure to Participate
• Failure to Diversify
• Failure to re-mortgage

Question 2

What do failure to Participate, and failure to diversify mean?

Answer 2

• Failure to Participate- not holding any risky assets

* Failure to Diversify- only holding one risky asset

Question 3

What is the difference between what Campbell (2006) describes as “positive household finance”, and “normal household finance”

Answer 3

• Positive Household Finance - What households actually do

* Normative Household Finance- How households “should” behave

Question 4

Do household’s positive and normal household finance often coincide?

Answer 4

No, often empirical findings of what household’s actually do differ from what an theorist would say a household “should” do.

Question 5

What is the Stockholding Puzzle?

Answer 5

Very few households actually hold risky assets (ie stocks), whereas one implication of portfolio theory is that all should participate in the financial markets, that is, all investors should invest in risky assets. This is especially shocking as there is a historical expected-return premium on equity relative to riskless assets.

Question 6

What will a risk averse individual that maximises expected utility do if stocks offer an expected premium return on risk free assets?

Answer 6

They will always invest in some risky assets, albeit perhaps a small amount.

Question 7

What is the opinion of a risk-averse person on riskiness to their consumption stream?

Answer 7

A risk averse person dislikes riskiness to their consumption stream.

Question 8

If a risky asset offers a higher expected return, then it will be deemed superior to the riskless asset unless what?

Answer 8

Unless the household values its contribution to the riskiness of consumption more than its contribution to the expected return on the portfolio

Question 9

Consider a household with riskless labour income and no stocks in its portfolio. The household considers adding a small amount of stocks versus adding an equal amount of the riskless asset. What should they do, and why?

Answer 9

Since the household holds no stocks, stock returns are not correlated with the household’s consumption and a marginal addition of stocks does not contribute to
consumption riskiness. Therefore, a marginal addition of stocks should be preferred to a marginal addition of the riskless asset by someone that holds no stocks.

Question 10

Give an example of direct stock holding and give an example of indirect stock holding.

Answer 10

• Direct stock holding could be directly purchasing £100 of AAPL
• Indirect stock holding could be investing into a pension fund.

Question 11

According to 2001 Survey of consumer Finances, Are people with higher or lower incomes more likely to invest in stocks? Do levels of education effect the amount of stock being purchased?

Answer 11

• People with higher incomes tend to invest more in stocks than those with lower incomes.
• People who have had more time in education tend to invest more in stocks than people with less time

Question 12

Which country’s households own the most stocks, and what % of households in that country do not own any?

Answer 12

In the USA, 57% of households own stocks, so 43% of households do not behave as our theory predicts.

Question 13

In the empirical literature, who claims higher levels of risk aversion are less level likely to hold risky stocks?

Answer 13

Haliassos and Bertaut (1995)

Question 14

In the empirical literature, who claims more risk averse individuals are less likely to hold risky assets, and hold a lower level of risky assets?

Answer 14

Rosen and Wu (2004)

Question 15

In the empirical literature, who claims more risk averse individual’s hold a lower proportion of risky assets in Australia?

Answer 15

Cardak and Wilkins (2009)

Question 16

What are 4 potential explanation for the Stockholding Puzzle?

Answer 16

• Fixed Costs- first time entrants may have to pay a fixed cost entry cost
• Background Risks (eg Health/Income/Unemployment Risks)
• Financial Literacy
• Behavioural Reasons (eg loss aversion)

Question 17

So what does empirical data suggest about risk averse people and how does this differ from our original expected utility model?

Answer 17

Empirical data suggests that risk averse people are less likely to participate, which differs from our expected utility model which doesn’t incorporate this factor.

Question 18

Are Fixed Costs monetary or non-monetary, and give examples.

Answer 18

Fixed costs are both monetary and non-monetary. Examples include:
•Administrative charges to set up an investment account
•Perceived costs
•Costs of time
•Costs of processing information
•Cost of choosing and monitoring advisors
•Keeping up with the market…

Question 19

What is a common reason why richer and more educated people have higher participation levels?

Answer 19

They tend to find it easier to overcome the initial fixed costs.

Question 20

What did Haliassos and Michaelidis (2003) present?

Answer 20

Haliassos and Michaelidis (2003) present a theoretical model of stockholdings which include fixed costs and find small costs to be sufficient for nonparticipation with plausible parameter values for e.g. risk aversion

Question 21

Which group of people do fixed costs mainly discourage?

Answer 21

Those who plan to hold a relatively small amount of risky assets.

Question 22

When we incorporate fixed costs, does this make other factors important determinants of risky asset market participation? If so give examples.

Answer 22

Yes incorporating fixed costs does make other factors important determinants of risky asset market participation. For example the risk aversion or the financial resources of an individual will influence whether they participate or not.

Question 23

What is a potential issue of blaming fixed costs as the reason for a lack of market participation?

Answer 23

As these costs do not explain why wealthier households don’t participate.

Question 24

Give reasons why fixed costs have decreased over time, and what is the resulting effect on participation levels?

Answer 24

Fixed costs have decreased over time due to, digitisation, the increase in online brokerages and financial deregulation. However, participation did not increase over this time period.

Question 25

Define financial literacy.

Answer 25

Financial literacy is the ability to obtain information, analyse, manage and communicate about one’s personal financial situation as it affects one’s material well-being.

Question 26

What did Lusardi and Mitchell (2008) find?

Answer 26

Lusardi and Mitchell (2008) - They found that financial illiteracy is widespread specific groups of the population, such as women, the elderly, and those with low educational attainment

Question 27

What did Bernheim and Garrett (2003) show?

Answer 27

Bernheim and Garrett (2003) show that those who were exposed to financial education in high school or in the workplace save more.

Question 28

What did Lusardi and Mitchell (2007) show?

Answer 28

Lusardi and Mitchell (2007) show that those who display low literacy are less likely to plan for retirement and, as a result, accumulate much less wealth.

Question 29

What did van Rooij et al. (2011) show in a representative sample of over 2000 Dutch households?

Answer 29

van Rooij et al. (2011) showed in a representative sample of over 2000 Dutch households that those with low financial literacy are much less likely to invest in stocks.

Question 30

What are background risks, how do they differ from financial market risks and what is the effect of them?

Answer 30

• Background risks can change peoples tolerance of stock market risks
• Background risks are unavoidable, exogenous and independent from financial market risks
• They can lead households to reduce their stockownership in order to limit their global exposure to risk

Question 31

Give 4 potential sources of background risks.

Answer 31

• Labour market income
• Real estate
• Future tax liabilities
• Health Risks

Question 32

What did Rosen and Wu (2004) show?

Answer 32

Rosen and Wu (2004) showed that healthier individuals are more likely to participate in holding risky assets.

Question 33

What did Carroll (2002) show?

Answer 33

Carroll (2002) showed that a small probability of being made unemployed has big effects on the likelihood of holding risky assets.

Question 34

What did Bertraut (1998) show?

Answer 34

Bertraut (1998) showed that income uncertainty was inversely related to risky asset holding (ie the more uncertain your income is, the less risky assets you hold)

Question 35

What did Palia, Qi and Wu (2014) report about housing values?

Answer 35

Palia, Qi and Wu (2014) reported that an increased volatility in house prices reduces a household’s stock holding.

Question 36

Can “fixing” one reason for the stockholding puzzle solve it?

Answer 36

No, as people all have different reasons for not investing in risky assets. For example for one person it could be financial literacy, but for another it could be the background risks.

Question 37

What is loss aversion?

Answer 37

Loss aversion describes the tendency to strongly prefer avoiding losses to acquiring gains (“losses loom larger than gains”).

Question 38

What did Benartzi and Thaler (1995) write about?

Answer 38

Benartzi and Thaler (1995) wrote about Myopic Loss Aversion

Question 39

What is Myopic Loss Aversion?

Answer 39

Myopic loss aversion occurs when investors take a view of their investments that is strongly focused on the short term, leading them to react too negatively to recent losses, which may be at the expense of long-term benefits.

Question 40

Is the utility of risky investments for a “myopic loss averse” investor smaller than for a loss averse investor?

Answer 40

Yes

Question 41

What does myopic loss aversion explain, and what doesn’t it explain.

Answer 41

• Explains equity premium puzzle using short evaluation periods
• However, not able to explain general non-participation over longer time periods

Question 42

Does myopic loss aversion fit more into a prospect theory behavioural based model of finance?

Answer 42

Yes

Question 43

Name 5 other factors which could be used to partially explain the stockholding puzzle.

Answer 43

• Asset ignorance (Guiso and Jappelli, 2005)
• Trust (Guiso et al., 2008)
• Social interactions (Hong et al., 2004)
• Substitution effects of private businesses for stocks (Heaton and Lucas, 2000)
• Subjective expectations (Dominitz and Manski, 2007)

Question 44

What does subjective expectations refer to?

Answer 44

Optimistic beliefs about stock returns are more likely to lead to higher levels of participation.

Question 45

What does asset ignorance refer to?

Answer 45

People simply not knowing what stocks and shares are, how can you participate in something you do not know exists?

Question 46

What does social interactions refer to?

Answer 46

In simple terms, if your friends own risky assets, you are more likely to purchase some as well.

Question 47

What does the equity premium puzzle suggest?

Answer 47

That more people should hold risky assets.

Question 48

What happens if households hold a large number of risky assets?

Answer 48

Diversifiable risk is eliminated, and so they only face systemic risk.

Question 49

Why are there measurement challenges to finding out which households diversify and how?

Answer 49

• Largely because households, especially the wealth do not like to share information on their finances.
• Furthermore surveys tend to show whether households do or don’t own assets, but they rarely contain data at the individual asset level (ie which assets people own)

Question 50

What did Calvet, Campbell and Sodini (2007) find through their research on Swedish citizens’ financial portfolios?

Answer 50

• Diversification is sought through holdings of mutual funds and not by individual stock ownership.
• The cost of diversification mistakes is quite small for most of the population but losses from under-diversification are potentially severe for households that hold a large fraction of financial wealth in risky assets.
• Better educated, richer, and more financially literate households have better diversified portfolios.

Question 51

What did Goetzmann and Kumar (2008) class as a “sophisticated investor”?

Answer 51

One that would engage in options, short-selling etc. Basically one with higher levels of financial literacy.

Question 52

What did Goetzmann and Kumar (2008) find?

Answer 52

Goetzmann and Kumar (2008) found that sophisticated investors held relatively better diversified portfolios, and that diversification levels increase with age, income, wealth and education.

Question 53

What did Guiso and Jappelli (2008) find?

Answer 53

Guiso and Jappelli (2008) also found that measures of financial literacy are strongly correlated with the degree of portfolio diversification.