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Diversification as a Public Good: Community Effects in Portfolio Choice

Authors

  • Peter M. Demarzo,

  • Ron Kaniel,

  • Ilan Kremer

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    • DeMarzo and Kremer are at Stanford University, and Kaniel is at Duke University. We thank Faye Wang for research assistance, and are grateful to Josh Coval, Rick Green, Dirk Hackbarth, Chris Hennessy, Harrison Hong, Stephen Shore, Chester Spatt, and an anonymous referee for useful discussions and suggestions, and are also grateful to seminar participants at Berkeley, Cal Tech, Colorado, Duke, NBER, SITE 2002, Stanford, UT Austin, the Utah Winter Finance Conference, and WFA. Ron Kaniel was at the University of Texas at Austin while this paper was written.


ABSTRACT

Within a rational general equilibrium model in which agents care only about personal consumption, we consider a setting in which, due to borrowing constraints, individuals endowed with local resources underparticipate in financial markets. As a result, investors compete for local resources through their portfolio choices. Even with complete financial markets and no aggregate risk, agents may herd into risky portfolios. This yields a Pareto-dominated outcome as agents introduce “community” risk unrelated to fundamentals. Moreover, if some agents are behaviorally biased, or cannot completely diversify their holdings, rational agents may choose more extreme portfolios and amplify the effect.

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