Diversification as a public good: Community effects in portfolio choice

Peter M. DeMarzo*, Ron Kaniel, Ilan Kremer

*Corresponding author for this work

Research output: Contribution to journalReview articlepeer-review

83 Scopus citations

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.

Original languageAmerican English
Pages (from-to)1677-1716
Number of pages40
JournalJournal of Finance
Volume59
Issue number4
DOIs
StatePublished - Aug 2004
Externally publishedYes

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