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Household Portfolio Diversification: A Case for Rank-Dependent Preferences

Household Portfolio Diversification: A Case for Rank-Dependent Preferences The proliferation of novel preference theories in financial economics is hampered by a lack of non-experimental evidence and by the theories’ additional complexity which has not been shown to be critical in applications. In this article I present arguments in support of preferences with rank dependency. Using the Survey of Consumer Finances data, I document two widespread patterns inconsistent with expected utility: (i) many households simultaneously invest in well-deversified funds and in poorly-diversified portfolios of stocks; and (ii) some households with substantial savings do not invest anything in equities. I show that portfolio choice models with rank-dependent preferences, plausibly parameterized and under fully rational assumptions, are quantitatively consistent with the observed diversification. These results call for further efforts to integrate the models of rank-dependent preferences in portfolio theory and asset pricing. http://www.deepdyve.com/assets/images/DeepDyve-Logo-lg.png The Review of Financial Studies Oxford University Press

Household Portfolio Diversification: A Case for Rank-Dependent Preferences

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References (62)

Publisher
Oxford University Press
Copyright
© The Author 2005. Published by Oxford University Press. All rights reserved. For Permissions, please email: journals.permissions@oupjournals.org
ISSN
0893-9454
eISSN
1465-7368
DOI
10.1093/rfs/hhi033
Publisher site
See Article on Publisher Site

Abstract

The proliferation of novel preference theories in financial economics is hampered by a lack of non-experimental evidence and by the theories’ additional complexity which has not been shown to be critical in applications. In this article I present arguments in support of preferences with rank dependency. Using the Survey of Consumer Finances data, I document two widespread patterns inconsistent with expected utility: (i) many households simultaneously invest in well-deversified funds and in poorly-diversified portfolios of stocks; and (ii) some households with substantial savings do not invest anything in equities. I show that portfolio choice models with rank-dependent preferences, plausibly parameterized and under fully rational assumptions, are quantitatively consistent with the observed diversification. These results call for further efforts to integrate the models of rank-dependent preferences in portfolio theory and asset pricing.

Journal

The Review of Financial StudiesOxford University Press

Published: Sep 2, 2005

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