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Ambiguity Aversion And Household Portfolio

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Question:

Discuss about the Ambiguity Aversion and Household Portfolio.
 
 

Answer:

Introduction:

The purchase of any item or assets in belief that it can produce maximum benefits or income in near future is called as the investment in general terms. In economics, goods are purchased to use them in the near future not in present conditions to generate maximum income or money is called as the investment. Residential, non-residential, human capital and inventory are some types of investments (Bodie et al, 2014). The technique of risk Management which includes different varieties for investment within any portfolio is called as the investment diversification. The reason to select investment diversification in economics is that different varieties of investments within any portfolio will produce higher returns on an average basis and also low risks associated with it as compared to investments which are done on individual basis within any portfolio. 

The diversification for household assets can be measured using the Gini Index. This index has been preferred for household diversification as it has both statistical and theoretical properties for the analysis and also all findings will be done by comparing equality diagonal with the Lorentz curve (Gaudecker and Von, 2015). Further, it measures all household distribution by directly comparing across population using certain specific weights. The index can be measured using the formula as,

The households during the diversification can also be classified into various components like superannuation, vehicles, business value, home value, bank accounts, trust funds, cash investments, equity investments, other assets value or insurance policies. From all these, bank accounts, superannuation and equity investments shares the largest part in household’s investment portfolio (Macours and Vakis, 2014). The household suffer various risks during the investment like health risk, expenditure risk or income risk associated with labour market. Further, there are several other factors as well which determines investment risk for the households like age, net worth, income, occupation, social interaction, living place, and educational attainment.

The household assets which are constrained with liquidity and who have more income or net worth have more chances to diversify their investments. The demographic factor like age will also affect diversification as increase in age will increase investment diversification factor and with less risks (Fransen and Mazzucato, 2014). The relation between social interaction and educational attainment will also enhance chances for more diversification in the investment and also reduces chances of risks on the investment within portfolio. If there is less investment on different assets, then there will be more chances of risks associated with household investment and will affect diversification of household assets. Further, the risk or returns for every household will be different and will depends on different categories like their income, net wealth, employability, age, living place and many more.

Corporations:

From the economical perspective, it has been found that diversification has certainly increased the borrowing capacity for most of the companies and corporations all across the globe. There are carious drivers which are associated with the corporate diversification like investment efficiency, productivity, financial constraints, and information asymmetry or agency conflicts (Hartzell et al, 2014). The diversification in corporations will provide more opportunities related to investment and capital funding.

The corporations who are looking to expand their business operations and market share will be mostly affected by the diversification. The diversification enables corporations to transfer their capital for different financial projects at expenses of other financial resources. These also reduce risks associated with cash flows and provide more access for the credits in order to enhance business operations. The diversification in corporations has enhanced cross pledging effect which certainly provides more finance for the companies to invest in order to enhance business operations (Junior and Funchal, 2013). The various empirical studies also define the investment advantages and different financial resources for the corporations from the diversification factor. It has also analysed that different credit constraints has also enhanced efficiency to allocate internal resources of finance in case of extreme harsh market conditions. The diversification will help in such cases to the companies to provide advantages of investment and at the same time also enable the corporations to allocate resources on more cost effective projects rather than on projects which are less efficient.

 

Further, diversification in case of corporations can be defined in two stages that are on the basis of Herfindahl index and on the basis of segments which are associated with the corporations. The Herfindahl index is mainly sum associated with percentages for net revenues on the reportable segments associated with the corporation’s (Najeeb et al, 2015). If there is one segment then the index’s value will be one and these provides its closeness to zero for the corporations which are more diverse in nature.

The corporation diversification defines negative relationship among growth opportunities and leverage. These also provide more growth opportunities for the corporations which have high leverage. The companies which are large in size have high diversification level and bankruptcy risks are also low which provides more credits facilities for such corporations (Damodaran, 2016). If corporations have not enough credit facilities then there will be more chances of bankruptcy resulted in lower degree level for diversification. Tangibility resources of corporations will provide more chances for diversification and reduces debt characteristics of the corporations in order to provide maximum leverage benefits.

Government:

It is the responsibility of the governments to protect funds of the public and also to manage public’s investment for achieving all investment objectives for liquidity, return and safety. Generally, if more risks associated with investment portfolio then there will be more opportunities for better returns. The Management for risks needs to be done effectively to achieve all objectives of the investment. Diversification is the medium which can be efficiently used as strategy to manage all the risks associated with the investment (Government Finance Officers Association, 2016). Government needs to implement targeted risk profiles which include constraints or objectives of investment, risk tolerances, current risks or liquidity requirements for the market. This type of profile helps to create framework to make all investment decisions on individual basis which reduces market risks and establish required structure for investment portfolio.  

Further, appropriate risk profile will help the government to determine diversification level. There are various risks associated with diversification related to government like interest rates, credit risk and liquidity risk (Dimmock et al, 2016). These risks can affect various business operations and other loan rates which can affect both the households and the corporations. If the interest rates for loans will be low, then there will be more chances for individuals and corporations to take loans so that can effectively invest on various objectives.   

Conclusion:

From the above discussion, it is evident that the various government policies are affecting the diversification level for both households and corporations. The bank rates needs to be reduced in order to enhance more investment opportunities for households and corporations as these will also create lower risk level for various financial activities. The various external factors like inflation or globalization may also affect the level of diversification. It is also observed that if there will be more investment then there will be more chances for more returns due to diversification and also reduces risk levels associated with different financial resources.

 

References:

Bodie, Z., Kane, A. and Marcus, A. (2014) Investments, 10e.USA: McGraw-Hill Education. 

Damodaran, A. (2016) Damodaran on valuation: security analysis for investment and corporate finance (Vol. 324).USA: John Wiley & Sons.

Dimmock, S., Kouwenberg, R., Mitchell, O. and Peijnenburg, K. (2016) Ambiguity aversion and household portfolio choice puzzles: Empirical evidence. Journal of Financial Economics, 119(3), pp.559-577.

Fransen, S. and Mazzucato, V. (2014) Remittances and household wealth after conflict: A case study on urban Burundi. World Development, 60, pp.57-68.

Gaudecker, H. and Von, M.  (2015) How does household portfolio diversification vary with financial literacy and financial advice?. The Journal of Finance, 70(2), pp.489-507.

Government Finance Officers Association (2016) Diversifying the Investment Portfolio. [Online]. Available at: https://gfoa.org/diversifying-investment-portfolio (Accessed: 25 April, 2017).

Hartzell, J., Sun, L. and Titman, S. (2014) Institutional investors as monitors of corporate diversification decisions: Evidence from real estate investment trusts. Journal of Corporate Finance, 25, pp.61-72.

Junior, J. and Funchal, B. (2013) The effect of corporative diversification on the capital structure of Brazilian firms. [Online]. Available at: https://www.scielo.br/scielo.php?pid=S1519-70772013000200006&script=sci_arttext&tlng=en (Accessed: 25 April, 2017).

Macours, K. and Vakis, R. (2014) Changing Households' Investment Behaviour through Social Interactions with Local Leaders: Evidence from a Randomised Transfer Programme. The Economic Journal, 124(576), pp.607-633.

Najeeb, S., Bacha, O. and Masih, M. (2015) Does heterogeneity in investment horizons affect portfolio diversification? Some insights using M-GARCH-DCC and wavelet correlation analysis. Emerging Markets Finance and Trade, 51(1), pp.188-208.

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