Discussion Paper Details

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Title: Investor Sophistication and Portfolio Dynamics

Author(s): Adrian Buss, Raman Uppal and Grigory Vilkov

Publication Date: July 2020

Keyword(s): Belief formation, household finance, investors' expectations, trend chasing and Wealth Inequality

Programme Area(s): Financial Economics

Abstract: We develop a dynamic general-equilibrium framework with multiple households and multiple risky assets to explain how less- and more-sophisticated households differ in their portfolio and wealth dynamics. Differences in sophistication are modeled via heterogeneous confidence about asset returns, coupled with Bayesian learning. Consistent with recent empirical evidence, less-sophisticated households overinvest in safe assets, hold underdiversified portfolios concentrated in familiar assets, are trend chasers, and earn lower absolute and risk-adjusted investment returns. Notably, this behavior is a consequence of optimal choices rather than investment mistakes. The model explains why this behavior, despite learning, persists for long periods, thereby exacerbating wealth inequality.

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Bibliographic Reference

Buss, A, Uppal, R and Vilkov, G. 2020. 'Investor Sophistication and Portfolio Dynamics'. London, Centre for Economic Policy Research.