Experience-based Learning, Stock Market Participation and Portfolio Choice

Abstract

Recent evidence suggests that lifetime experiences play an important role in determining households' investment choices. I incorporate these findings and the fact that household portfolios are underdiversified into an otherwise standard life-cycle model and examine to what extent they can help resolve long-standing puzzles in the literature regarding stock market participation and the fraction of financial wealth invested in risky assets. I show that experience-based learning about returns creates a positive correlation between a household's position in the wealth distribution and its optimism about future returns. The wealthy consequently increase their investment in risky assets, while participation is limited among poor households. I find that in a reasonably calibrated quantitative model, this mechanism is able to close approximately half of the gap between participation rates observed in the data and the predictions from standard models. On the other hand, the average conditional risky share remains mostly unaffected.

Keywords: Stock-market participation, portfolio choice, learning, subjective beliefs, underdiversification

JEL Classification: E21, E7, G40, G51