Quantitative Economics: Mar, 2012, Volume 3, Issue 1

Do disaster expectations explain household portfolios?

Sule Alan

It has been argued that rare economic disasters can explain most asset pricing
puzzles. If this is the case, perceived risk associated with a disaster in stock mar-
kets should be revealed in household portfolios. That is, the framework that solves
these pricing puzzles should also generate quantities that are consistent with the
observed ones. This paper estimates the perceived risk of disasters (both proba-
bility and expected size) that is consistent with observed portfolios and consump-
tion growth between 1983 and 2004 in the United States. I find that the portfolio
choices of households that have less than a college degree can be partially ex-
plained by expectations of stock market disasters only if one allows for a large
probability of labor income loss at the same time. Such disaster expectations,
however, are not revealed in the portfolios of educated and wealthier households:
simple per-period participation costs of the stock market coupled with preference
heterogeneity explain their participation and investment patterns.
Keywords. Household portfolios, disasters.
JEL classification. D91, E21

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