Does Household Finance Matter? Small Financial Errors with Large Social Costs

Households with familiarity bias tilt their portfolios towards a few risky assets. Consequently, household portfolios are underdiversified and excessively volatile. To understand the implications of underdiversification for social welfare, we solve in closed form a model of a stochastic, dynamic, general-equilibrium economy with a large number of heterogeneous firms and households, who bias their investment toward a few familiar assets. We find that the direct mean-variance loss from holding an underdiversified portfolio that is excessively risky is a modest 1.66% per annum, consistent with the estimates in Calvet, Campbell, and Sodini (2007). However, we show that in a more general model with intertemporal consumption, this loss is amplified because it increases household consumption-growth volatility. Moreover, in general equilibrium where growth is endogenous, we show that the welfare losses of individual households are magnified further through the externality on aggregate investment and growth.