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RFS Advance Access originally published online on April 13, 2007
Review of Financial Studies 2007 20(5):1623-1646; doi:10.1093/rfs/hhm022
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Copyright © The Author 2007. Published by Oxford University Press on behalf of The Society for Financial Studies.

The Forgone Gains of Incomplete Portfolios

Monica Paiella
Bank of Italy, Research Department, Via Nazionale 91, Rome 00184, Italy

Address correspondence to Monica Paiella, Bank of Italy, Research Department, Via Nazionale 91, Rome 00184, Italy; Tel: +39.06.4792.2595; Fax: +39.06.4792.3723, or e-mail: monica.paiella{at}bancaditalia.it.

JEL: G11, D12, E21


  Abstract

This article proposes a test for the cost-based explanation of nonparticipation, by estimating a lower bound to the forgone gains of incomplete portfolios; these are in turn a lower bound to the costs that could rationalize nonparticipation in financial markets: high bounds would imply implausibly high costs. Assuming isoelastic utility and a relative risk aversion of three or less, for the stock market I estimate an average lower bound of between 0.7 and 3.3 percent of consumption. Since total annual (observable plus unobservable) participation costs are likely to exceed these bounds, the cost-based explanation is not rejected by this test.

The views expressed are those of the author and do not necessarily reflect those of the Bank of Italy. I am grateful to Orazio Attanasio for his advice and suggestions. I have also benefited from comments by Richard Blundell, John Cochrane, Janice Eberly, Dario Focarelli, John Heaton, Erzo Luttmer, Andrea Tiseno, Annette Vissing-J\orgensen, two anonymous referees, the editor, Maureen O'Hara and participants to the seminars at the University College London, Institute for Fiscal Studies, Bank of Italy, and the NBER Summer Institute on the Aggregate Implications of Microeconomic Behavior.


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D. Easley and M. O'Hara
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Rev. Financ. Stud., May 1, 2009; 22(5): 1817 - 1843.
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