Households can allocate their savings in many ways. Not only are there several broad asset classes, but within any one class there is often a huge variety of choices. With so many alternatives to choose from, it is not surprising that some households have difficulty choosing a portfolio. Evidence of these difficulties takes several forms. Researchers have looked at micro-level data on household portfolios and found that some households allocate savings in ways that are hard to rationalize with standard economic models. For example, households may not allocate any savings to equities or they may hold under-diversified portfolios (for examples see Haliassos and Bertaut [1995] and Calvet, Campbell and Sodini [2007]). Surveys of financial literacy have also found that many households do not understand some fundamental financial concepts such as the difference between bonds and stocks (van Rooij, Lusardi and Alessie [2007]).
Other studies have found that those households that spend more effort planning for retirement reach retirement age with more wealth (Ameriks, Caplin and Leahy [2003] and Lusardi and Mitchell [2007]). In addition, researchers have found that experimental subjects have difficulty making sound financial decisions even when there is a clear normative ranking of the available choices (Choi, Laibson and Madrian [2010]). Many of these studies find that households with higher levels of income, wealth and education have more success in making sound financial decisions.
One way of understanding this empirical evidence is to view managing a portfolio as an activity that requires effort, with the incentive to devote effort varying across households. For example, households with high levels of wealth have more to gain in absolute terms from improving the return on their portfolios. Alternatively, highly educated households may be better able to assess the various risks and trade-offs that arise in choosing a portfolio. In this paper, I develop a general equilibrium model of household saving behavior in which households must exert effort to learn about the available investment opportunities by searching for high returns. In the model, a household can raise the expected return on its portfolio by devoting more effort to search. The benefit of search exists because there is dispersion in the rates of return offered by financial intermediaries.
When households are imperfectly informed, intermediaries can still attract savings even if they are not offering the highest return, but intermediaries that offer higher returns will attract more savings. Therefore, intermediaries face a trade-off between the number of savers they will attract and their profit margin. In the model, these competing forces balance in such a way that intermediaries choose to offer a range of returns, which gives rise to an endogenous distribution of offered returns that depends on the search and saving behavior of households.
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Household Saving Behavior and Social Security Privatization
