DP15116 Investor Sophistication and Portfolio Dynamics

Author(s): Adrian Buss, Raman Uppal, Grigory Vilkov
Publication Date: July 2020
Keyword(s): Belief formation, household finance, investors' expectations, trend chasing, Wealth Inequality
JEL(s): D53, G11, G51, G53
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=15116

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.