Cabo Sobre a emerxencia da escrita romance en Galicia

The composition of household financial portfolios has been analysed extensively in the literature both theoretically and empirically. One of the most important the- ories of households’ financial behaviour is the classical theory of household financial

portfolios developed and first formalized byMarkowitz(1952). This theory links the

optimal portfolio composition to the return on an asset and the variance of this re-

turn in an extremely parsimonious model. Tobin (1958b) expanded on Markowitz’s

work, building on the same assumptions and structure of the classical theory, and further illustrates that an investor’s degree of risk aversion will determine the con- vexity of their utility function. Hence, investors will maximise their utility function based on the risk-return pattern of available assets, the level of their total wealth and their degree of risk aversion. Theories which are built on the standard expected utility framework consider risk preferences as central and a key ingredient in mod-

elling financial decisions. For example, the classical Merton (1969) and Samuelson

(1969) models of consumption and portfolio choice directly link the fraction of finan-

cial wealth invested in risky assets to the individual’s degree of risk aversion and the distribution of the return on assets. In particular, the investor’s optimal proportion of risky assets under the assumptions of these models can be defined as:

λi =

E(Rr) − Rf

γiσ2r

, (3.1)

where λi is the proportion of financial wealth invested in risky assets, (E(Rr) −

Rf) is the expected risk premium, σr is the return volatility of risky assets, and γi

is the degree of relative risk aversion.7

The models described above are based on strong assumptions such as: no partici-

7_{Where R}

pation or transaction costs; markets are complete; no labour income; risk-free assets generate a constant return; and wealth is held in a liquid form. Based on these unre-

alistic assumptions, two important implications can be observed fromEquation 3.1:

the first one is that rational investors will participate in the stock market given that

(Rr − Rf) > 0, no matter how risk averse an investor is. The second implication

is that the risk aversion parameter γi will ascertain that all heterogeneity in the

observed portfolio shares is related to differences in the risk preference of investors. This implies that the observed portfolio shares are independent of, for example, investor’s age and wealth under the assumption of constant absolute risk aversion. However, the observed risky asset holdings across countries contradict these two im- plications, despite the historical positive risk premium observed in most countries.

For example, recent data used byBadarinza et al. (2016) shows that there is a high

percentage of household that do not hold any risky assets and also the proportions of risky assets held by households are much lower than what the classical theory pre- dicts. Moreover, the data shows that stock market participation rates differ across countries and change over time. The implication that age and wealth are indepen- dent of risky asset holdings is also contradicted by the documented inverse-U shape

of age effect on an individual’s risky asset allocation. For example, Ameriks and

Zeldes (2004) analysed household asset allocation behaviour in the U.S. and found

that risky asset shares have a hump-shaped relationship to age. Guiso, Haliassos,

and Jappelli (2002) found similar patterns for the European countries.

The strong assumptions of the classical theory are behind its limitation in ac- counting for the observed stock holding heterogeneity. For example, the fact that in reality investors face participation costs might explain the high percentage of zero risky asset holdings, which is referred to as the “participation puzzle” in the literature. These costs are associated with the information needed for an investor to be able to form a portfolio close to the market portfolio and are also associated

with the cost of trading needed to form a diversified portfolio.8 _{Hence, even small}

participation costs are sufficient to keep many households out of the stock market as the benefit from holding risky assets is too small to offset this fixed cost, see

Haliassos (2003). The other unrealistic assumption of the classical theory is that wealth is held in a liquid and tradeable form. A large component of household wealth is allocated to housing, which is an illiquid non-financial asset, or in the form of the non-tradeable human capital, as households cannot sell claims to this capital. Finally, assuming that investors have no labour income is another unreal- istic assumption as labour income and the risk associated with its uncertainty are important determinants of risky asset holdings as the literature suggests.