Household Portfolio Diversification: A Case for Rank Dependent Preferences

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 paper 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-diversified 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. This paper was previously circulated under the title "Household Portfolio Diversification." The paper has benefited from the comments of Shlomo Benartzi, Luca Benzoni, Markus Brunnermeier, John Dickhaut, Maria Pirozek, Raj Singh, Hersh Shefrin, and workshop participants at Minnesota Finance bag lunch, 2003 Wharton conference "Household Financial Decision Making and Portfolio Choice", and 2003 summer meetings of Econometric Society. I would like to thank Cam Harvey (the editor) and an anonymous referee for many helpful comments and suggestions. A special thanks to Jack Kareken for comments and editorial help on an earlier draft. I am grateful to Donna Zerwitz for editorial assistance. The views expressed herein are those of the author and not necessarily of the Federal Reserve Bank of Minneapolis or the Federal Reserve System. All errors and omissions are sole responsibility of the author.

Keywords: Diversification, portfolio choice, rank dependent preferences

JEL Classifications: G11

Working Paper Series