The Choice Channel of Financial Innovation

Abstract

Financial innovation in recent decades has expanded portfolio choice. We investigate how greater choice affects investors' savings and asset returns. We establish a choice channel by which greater portfolio choice increases investors' savings---by enabling them to earn the aggregate risk premium or to take speculative positions. In equilibrium, portfolio customization (access to risky assets beyond the market portfolio) reduces the risk-free rate. Participation (access to the market portfolio) reduces the risk premium but typically increases the risk-free rate. Empirically, stock market participants in the U.S. save more than nonparticipants, and have increasingly dispersed portfolio returns, consistent with the choice channel.

Keywords: belief disagreements, Customization, financial innovation, interest rate, Risk premium, Savings, Speculation, Stock Market Participation

JEL Classification: E21, E43, E44, G11, G12