Investor Sophistication and Portfolio Dynamics

Abstract

We develop a simple dynamic general-equilibrium framework that can jointly rationalize many empirically observed features of household portfolios, investment returns, and wealth dynamics. The model differs from traditional models only along a single, natural dimension: households differ in their confidence about the return processes for risky assets. Less-confident households (but with unbiased beliefs) overinvest in safe assets, hold underdiversified portfolios concentrated in familiar assets, are trend chasers, and earn lower absolute and risk-adjusted investment returns. More confident households hold riskier positions and exhibit superior market-timing abilities. Despite Bayesian learning, this investment behavior persists for long periods, thereby exacerbating wealth inequality.

JEL Classification: D53, G11, G51, G53