Household Investments, Limited Participation and Equity Premium with Wealth Heterogeneity

Abstract

We develop and solve analytically a general equilibrium model where investors have heterogeneous wealth levels and exhibit uncertainty aversion. The model explains several salient patterns of household investments: (i) a sizeable fraction of households do not participate in the stock market, (ii) richer households are more likely to participate, and (iii) among the households that do participate, wealthier ones invest a larger share of their wealth into risky assets. We also study the relation between the equity premium and market participation as a function of household wealth. For wealth growth that preserves or decreases wealth inequality, the resulting higher participation level is associated with a lower equity premium; whereas a rise in wealth inequality leads to the opposite relationship: lower participation at a lower equity premium.

Keywords: household portfolios, limited participation, equity premium, wealth heterogeneity, uncertainty aversion

JEL Classification: G11, G12, D81