Diversification as a Public Good: Community Effects in Portfolio Choice

Abstract

In this paper, we propose an explanation for biases in portfolio choice. We show that if individuals compete for local resources within their community, their utility depends on their own wealth as well as aggregate community wealth. This leads to an externality in portfolio choice. If investors are sufficiently risk averse, then individual investors will bias their portfolio choice in the direction of the aggregate portfolio choice of the community. These results are derived under standard utility functions in which agents care only about their own consumption bundle.

We consider a setting in which, due to borrowing constraints, individuals in the community who are endowed with the local resource under-participate in financial markets. As a result, we show that even with complete financial markets and no aggregate risk, in all stable equilibria investors within a community "herd" into an undiversified portfolio. In addition, if some investors cannot completely diversify their holdings of local firms (perhaps due to moral hazard), the unique equilibrium is one in which all investors are biased towards local firms, and moreover the constraint against full diversification need not bind. Similarly, if some agents exhibit an arbitrary behavioral bias, then other rational agents would trade in the same direction, amplifying (and "rationalizing") the behavioral effect. We also show that in our model, equilibrium Sharpe ratios can be high, even absent aggregate consumption risk. As a result, we argue that diversification has "public good" features, and that policies that limit trade in risky securities can enhance welfare.

Note: Previously titled "Community Effects and Externalities in Portfolio Choice"

Keywords: public good, community, diversification, portfolio choice, home bias