Heterogeneity and Portfolio Choice: Theory and Evidence

In this paper, we summarize the evidence on the large and systematic differences in portfolio composition across individuals with varying characteristics, and evaluate some of the theories that have been proposed in terms of their ability to account for these differences. Variation in background risk factors, from sources such as labor and entrepreneurial income or real estate holdings, transactions costs, and life cycle considerations, can explain some but not all aspects of cross-sectional observations of portfolio holdings in a traditional utility maximizing framework. Remaining challenges for quantitative theories include a compelling explanation for the high rate of non-participation in the stock market despite a considerable equity premium, and the apparent lack of diversification of many individual portfolios.