Household Finance (Digest Summary)

Household finance studies how households use financial instruments to achieve their
objectives. Unique features of household finance problems include a long but finite
planning horizon, nontraded assets, illiquid assets, borrowing constraints, and complex
taxation. Many households invest efficiently, but a minority makes investment mistakes.
Cross-subsidies in existing markets from naive to sophisticated investors may inhibit
financial innovation.

Ideal household financial data would provide highly accurate information on individual
households over time that is representative of the entire population, would present
exhaustive details as well as total wealth, and could be disaggregated to individual
assets. Necessary data are difficult to obtain primarily because individuals tend to
guard their privacy and may have a complicated set of financial arrangements. Various
incomplete datasets exist, but the absence of a complete set hampers household finance
measurement.

Modeling household behavior is difficult because households face constraints not
considered in standard finance texts. Examples of complexity are the following: (1)
Idiosyncratic risk of nontradable human capital cannot be hedged; (2) housing, the
dominant household asset class, is illiquid; and (3) households may face binding
borrowing constraints in the present or future. Empirical models following
Merton’s consumption and intertemporal capital asset pricing model explain some
discrepancies between mean–variance analysis predictions and what financial
planners advise. The assumptions of these models that assets are liquid and tradable,
however, are contradicted by idiosyncratic unhedgeable labor income risk. The usefulness
of these models is also limited by the presence of illiquid housing, borrowing
constraints, and a complex tax structure.

U.S. data show that low-wealth households have little or no financial assets, and even
those higher in the wealth scale have limited holdings of public equity. Housing is the
dominant asset of the middle class. Equity is the dominant portfolio share only for
high-wealth households that more willingly accept risk. Education, income, and wealth
have strong effects on participation in public equity markets. The main influence on
portfolio shares, both for public and private equity, is wealth. Nonparticipation in
risky asset markets is an investment mistake that less-educated and poorer households
are more likely to make.

Brokerage account data on U.S. asset allocations within each asset class show that many
households own only a few individual stocks, but this risk may be offset by indirect
ownership through mutual funds and retirement accounts. Many households own large
holdings of their employers’ stock. There is a strong local bias in asset
holdings.

Household data gathered by the Swedish government provide one of the most comprehensive
datasets. These data show broadly consistent asset allocation patterns between the
United States and Sweden. Sophisticated Swedish households tend to follow investment
strategies closer to those recommended by standard financial theory. Overall, Swedish
investors take substantial idiosyncratic risk, but the negative effect on the typical
household’s welfare is modest. Like U.S. households, many Swedish households do
not participate in risky asset markets. Household decisions to hold fixed-rate mortgages
(FRMs) or adjustable-rate mortgages (ARMs) may result from borrowers’ perception
that they lack the skills to invest efficiently. Households must consider variables such
as the likelihood of moving, present and future borrowing constraints, real interest
rate risk, and inflation risk within the context of the household’s risk aversion.
Apparently, some households believe, incorrectly, that long-term interest rates are mean
reverting, and they choose between ARMs and FRMs accordingly. Another investment mistake
that households make regarding mortgages is the failure to refinance FRMs when
conditions justify.

Slowness of innovation in retail financial markets is a puzzle. The author argues that
existing products reward sophisticated households at the expense of unsophisticated
households in a way such that no one is motivated to introduce simpler, new products.
This cross-subsidy may inhibit financial innovation.

The author concludes that many households invest efficiently, but a minority of
households that face complex investment decisions make serious investment mistakes.
Serious mistakes are not participating in risky asset markets, underdiversifying risky
portfolios, and not refinancing fixed-rate mortgages. Some markets involve
cross-subsidies that may inhibit financial innovation.