Friday, July 7, 2017

"Risk, return, and skill in the portfolios of the wealthy"

From VoxEU, July 7:
A growing literature conjectures that wealthy households earn higher average returns, which can further exacerbate wealth inequality. Using Swedish administrative data, this column shows that the wealthy indeed earn higher returns on their asset portfolios. These high returns are primarily due to high levels of compensated risk. Households at the top of the wealth distribution further exhibit highly heterogeneous investment performance due to high levels of idiosyncratic risk.
The concentration of wealth far exceeds the concentration of labour income, and exhibits rapid growth in the US and around the world (Piketty 2014, Saez and Zucman 2016). Economic theory suggests that capital income should play a fundamental role in explaining these facts because returns on household savings accumulate multiplicatively over time (Benhabib Bisin and Zhu 2011, Cagetti and de Nardi 2008). Furthermore, the impact of capital income might be considerably magnified if the wealthy select portfolios with higher and riskier returns than the middle class, as Piketty (2014) and Gabaix et al (2016) suggest.

The data challenge
Empirical research on capital income has until now been hampered by the lack of accurate micro data. To analyse the investments of the wealthy, one needs to use a dataset that extensively samples households at the very top and gives them incentives to truthfully report their assets. Holdings should also be measured exhaustively, preferably at the level of each asset or security. Traditional datasets do not meet these requirements. For instance, the US Survey of Consumer Finances contains only about 700 households from the top 1% of the wealth distribution, and the response rate in the top percentile is only 12%.

In a recent paper, we overcome these limitations by considering an extensive administrative panel containing the wealth records of Swedish residents at the end of each year (Bach et al. 2017). The dataset contains 42,000 households each year from the top 1% of the wealth distribution. It contains the debt and disaggregated holdings of every household, reported at the level of each bank account, financial security, private firm, and real estate property.

Risk and return characteristics of gross wealth
We term total gross wealth a household’s portfolio of financial, real estate, and private equity assets, excluding debt from consideration. Wealthier households allocate a substantially higher fraction of total gross wealth to risky assets compared to the median household. The share of risky assets increases monotonically with net worth, reaching 21% for the median household, 62% for the top 1%-0.5%, and 95% for the top 0.01%.

High-net-worth households correspondingly take high levels of risk, as Figure 1, Panel A, illustrates. They achieve high systematic exposure:
  • by allocating a high share of gross wealth to risky assets; and
  • by picking risky assets that load aggressively on systematic risk factors.
Wealthy households also bear highly idiosyncratic risk through substantial direct holdings of private and public equity.

As a result of these risk exposure patterns, the expected return on total gross wealth monotonically increases with household net worth. Compared to the median household, the expected return on total gross wealth is 2.7% per year higher for the top 10%-5% of households, 4.1% per year higher for the top 1%-0.5%, and 6.2% per year higher for the top 0.01% (see Figure 1, Panel A). These results confirm the conjecture of Benhabib et al. (2011), Piketty (2014), and others that wealthier households earn higher average returns.

The importance of leverage
We next consider household net wealth, defined as total gross wealth minus debt. In contrast to gross wealth, net wealth earns an expected return that is U-shaped across brackets of net worth (see Figure 1, Panel B). Middle-class households have highly leveraged positions in real estate that generate high mean returns on net wealth. Upper-middle-class households have lower leverage and lower average returns. At the very top, households have very little personal debt but achieve high expected returns by bearing high systematic risk....MUCH MORE