Investor Behavior: The Psychology of Financial Planning and Investing

CHAPTER 5

Household Investment Decisions

Vicki L. Bogan

Associate Professor, Cornell University

INTRODUCTION

Household portfolio choices are vital to economic advancement and wealth building, particularly during prosperous economic times. Moreover, recessionary cycles often magnify the economic importance of individual and household financial decision-making. The subprime mortgage crisis of 2008 is a good example of how individual household mortgage decisions had a tremendous effect on financial markets and the economy as a whole. Understanding how household characteristics influence portfolio choice is important to understanding both distributional welfare issues and broader financial market effects (Campbell 2006). Nonetheless, an important limitation of almost any traditional finance model is the imperfect ability to fully reflect actual individual and household financial decision-making behavior.

Traditional (standard) finance theory describes the investment choices that households should make to maximize household welfare—normative household finance models. However, actual and optimal behavior do not always coincide. Thus, the positive study of household financial decision-making behavior is important to better inform tax-related policies, pension-related policies, and regulation of financial markets.

The chapter is organized as follows. The first section discusses financial market participation. The second section presents the effects of market frictions on general individual ...