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Diversification as a Public Good: Community Effects in Portfolio Choice

50 Pages Posted: 2 Mar 2002  

Peter M. DeMarzo

Stanford Graduate School of Business; National Bureau of Economic Research (NBER)

Ron Kaniel

University of Rochester - Simon Business School; CEPR

Ilan Kremer

Independent

Date Written: April 5, 2002

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.

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

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

Suggested Citation

DeMarzo, Peter M. and Kaniel, Ron and Kremer, Ilan, Diversification as a Public Good: Community Effects in Portfolio Choice (April 5, 2002). Twelfth Annual Utah Winter Finance Conference; Texas Finance Festival. Available at SSRN: https://ssrn.com/abstract=302953 or http://dx.doi.org/10.2139/ssrn.302953

Peter M. DeMarzo

Stanford Graduate School of Business ( email )

655 Knight Way
Stanford, CA 94305-5015
United States
650-736-1082 (Phone)
650-725-7979 (Fax)

HOME PAGE: http://www.stanford.edu/people/pdemarzo

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Ron Kaniel (Contact Author)

University of Rochester - Simon Business School ( email )

Rochester, NY 14627
United States

HOME PAGE: http://rkaniel.simon.rochester.edu

CEPR ( email )

77 Bastwick Street
London, EC1V 3PZ
United Kingdom

Ilan Kremer

Independent

No Address Available

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