Loss-aversion and household portfolio choice

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Abstract

In this paper we empirically test if loss-aversion affects household participation in equity markets, household allocations to equity, and household allocations between mutual funds and individual stocks. Using household survey data, we obtain direct measures of each surveyed household's loss-aversion coefficient from questions involving hypothetical payoffs. We find that higher loss-aversion is associated with a lower probability of participation. We also find that higher loss-aversion reduces the probability of direct stockholding by significantly more than the probability of owning mutual funds. After controlling for sample selection we do not find a relationship between loss-aversion and portfolio allocations to equity.

Introduction

Calibrated models of household portfolio choice with standard preferences suggest that in frictionless economies almost all households should own equity (e.g., Haliassos and Bertaut, 1995; Heaton and Lucas, 1997). Empirical studies have found equity market participation much lower than is implied by these models (Bertaut, 1998; Haliassos and Bertaut, 1995; Vissing-Jorgenson, 2002). Explanations for this divergence have focused on two explanations: frictions such as background risk and investment costs,1 and non-standard preferences such as loss-aversion.

Loss-aversion implies that households frame events as either gains or losses relative to a reference point, and weight losses more heavily than gains. Theoretical papers such as Ang et al., 2004, Barberis et al., 2006, Benartzi and Thaler, 1995, Berkelaar et al., 2004, Gomes, 2005, Polkovnichenko, 2005 show that loss-averse households will either not participate in equity markets, or they will allocate considerably less of their wealth to equities relative to households with standard preferences.

In this paper we empirically examine how loss-aversion affects household portfolio choice. The DNB Household Survey conducted in The Netherlands contains a series of intertemporal choice questions based on experimental work by Thaler, 1981, Loewenstein, 1988. Similar to Tu (2004), we use these questions to measure household loss-aversion. We then show that this measure has significant explanatory power for households' equity market participation decisions and the choice between mutual funds and direct stockholding.

Following Tu (2004) we measure loss-aversion from 16 survey questions involving the speed-up and delay of payoffs, both gains and losses. With standard utility functions, people will have a single discount rate across gains and losses, and across speed-up and delay. This prediction is strongly violated in the responses to these questions. Most people require much higher compensation to delay receiving a sure gain than the amount they are willing to pay to expedite receipt of the same gain. Loewenstein, 1988, Loewenstein and Prelec, 1992, Thaler, 1981 show that a loss-averse individual who does not integrate payments with existing consumption plans, but rather frames the payments as gains and losses relative to a reference point, can have multiple discount rates. The predictions of these models are supported by experiments conducted by Benzion et al., 1989, Loewenstein, 1988, Shelley, 1993, Thaler, 1981 among others. Frederick et al. (2002, p. 370) explain the intuition behind this result as follows: “Shifting consumption in any direction is made less desirable by loss-aversion, since one loses consumption in one period and gains it in another. When delaying consumption, loss-aversion reinforces time discounting, creating a powerful aversion to delay. When expediting consumption, loss-aversion opposes time discounting, reducing the desirability of speed-up…”.

Clearly a key issue for this paper is the reliability of our measures of loss-aversion. We test the internal consistency of our measures in two ways. First, as we have multiple questions designed to measure the same set of latent variables, we use Cronbach's alpha — the standard psychometric test for reliability in these cases — and find strong evidence to support the notion that similar questions are consistently measuring the same underlying concepts. Second, there are simple, logical relations which must hold between many of the responses. We find that only a small percent of household responses violate these relations. Further we show that the responses to the DNB Household Survey are both qualitatively and quantitatively similar to a large number of experimental studies. Finally, we discuss other potential explanations for the pattern of responses and show that the data reject alternative explanations.

We hypothesize that our empirical measure of loss-aversion is a proxy for the level of loss-aversion that households experience when investing in actual markets. Using our loss-aversion measure we show that households with higher loss-aversion are significantly less likely to participate in equity markets. For an average household if their estimated loss-aversion coefficient increases from the 25th to the 75th percentile, the probability of owning stocks decreases by 7%, relative to the sample mean. These results are robust to controlling for a direct survey measure of risk-aversion and a wide variety of other variables used in previous studies, such as age, education, income, financial wealth, and unsecured debt. Although loss-aversion predicts household equity market participation, after controlling for sample selection we do not find a significant relationship between loss-aversion and portfolio allocations.

If investors are loss-averse and exhibit narrow framing, meaning they evaluate gains and losses on securities in isolation rather than after integrating their entire portfolio, then the bundling of returns will affect the relative attractiveness of mutual funds and individual stocks. Consistent with this idea, we find that loss-aversion affects the type of equity that households hold. Households with higher loss-aversion avoid investing in individual stocks to a greater extent than they avoid mutual funds.

This paper provides direct empirical evidence on the importance of loss-aversion for household decision making. To our knowledge it is the first paper to empirically measure the heterogeneity in loss-aversion across a representative sample of households and use this information to explain household portfolio choice.

This paper is related to a branch of the literature on household portfolio choice that shows how psychological factors measured through survey questions can predict household equity market participation. Barsky et al. (1997) show that hypothetical questions designed to measure risk-aversion are significantly related to household stock market participation. Hong et al. (2004) show that more social households are more likely to participate in the equity market. Guiso et al. (2008) show that households that are more trusting of others have higher participation rates and allocations to equity. Puri and Robinson (2007) show that optimism and equity market participation are related.

The remainder of this paper is organized as follows. Section 2 outlines the theories and hypotheses tested in this paper. Section 3 describes the data source and the variables. Section 4 presents and discusses our measure of loss-aversion. Section 5 presents the results. Section 6 concludes.

Section snippets

Theory and hypotheses

Heaton and Lucas (1997) calibrate a model of a representative household's portfolio choice using standard utility functions and parameter values drawn from the US economy. They find that all households should participate in equity markets and that, in the absence of market frictions, they should allocate all of their financial wealth to equity. However, numerous empirical papers have shown that many households do not participate in the equity market, and many participants own only small amounts

Data

The data source for this paper is the CentERdata DNB Household Survey, a household survey conducted by CentERdata at Tilburg University in The Netherlands.7 We use this dataset because it contains information about household wealth, income, and financial assets, as well as a set of questions we can use to extract a measure of loss-aversion. This paper uses data from the 1997–2002 waves of the DNB

Measuring loss-aversion

In addition to demographic information, income, and wealth, the DNB Household Survey also contains an “Economic and Psychological Concepts” module. This module includes a series of questions based on work by Thaler, 1981, Loewenstein, 1988, showing that loss-aversion affects intertemporal choice. Thaler shows that individuals discount gains and losses at different rates. Loewenstein shows a related result; individuals will demand more to defer receipt of a payment than they will pay to expedite

Results

In this section we estimate the relation of loss-aversion and estimated reference points with equity ownership. We show that households with higher reported loss-aversion are less likely to participate in the equity market and avoid direct stockholding to a greater extent than mutual funds. After controlling for sample selection, we do not find a significant relation between loss-aversion and allocations to equity.

Conclusion

Despite the high equity premium many households choose not to participate in the equity markets, and across participating households there is great heterogeneity in allocations to equity. These empirical facts are difficult to reconcile with normative results obtained from frictionless models using standard utility functions. One proposed explanation for these facts is that households do not in fact have standard utility functions but are loss-averse. In this paper we empirically test how

Acknowledgement

We would like to thank Jeffrey Brown, Louis K.C. Chan, Bing Han, Terry Odean, Joshua Pollet, Thierry Post, Allen Poteshman, Joshua White, William Ziemba, three anonymous referees, and seminar participants at Case Western Reserve University, Michigan State University, Tulane University, University of Alberta, University of Illinois at Chicago, University of Illinois at Urbana-Champaign, and the People and Money Conference at DePaul University for helpful comments. This paper uses data from the

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