Explaining Households’ Investment Behavior

Abstract

Building on a framework of heterogeneous uncertainty across the population, this paper provides a unified theoretical explanation for several salient features of household investment behavior: First, a fraction of households will choose not to participate in the stock market, with poorer households less likely to participate. Second, among the part of the population that does choose to invest, wealthier households choose to invest a larger share of their wealth into risky assets than less wealthy households. The model suggests that as aggregate wealth rises, we should see higher levels of stock market participation. We build on a CARA-normal framework with uncertainty-averse investors and link the level of uncertainty to investor wealth, given the empirical evidence that wealthier investors tend to acquire more costly information. The model is able to reconcile previous conflicting findings: our model shows that the intuition of models with exogenous participation restrictions - limited stock market participation leads to a higher equity premium - can indeed be retained when the participation decision is endogenized.