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Neighborhood Effects and Asset Allocation

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1 Neighborhood Effects and Asset Allocation October 18, 2008 James Chong* James P. Dow, Jr. G. Michael Phillips Dept. of Finance, Real Estate, & Insurance California State University, Northridge Previous research has shown racial/ethnic effects in asset allocation. We extend these results by showing how these effects depend on the racial composition of the neighborhood. In particular, we show that in predominately white neighborhoods there are significant differences in asset allocations across racial groups; however, in mixed or white minority neighborhoods, this difference disappears. We also find that Asians, a previously understudied group, show a greater willingness to hold risky assets compared with other groups. *Corresponding author, James Chong, Department of Finance, Real Estate, & Insurance, California State University, Northridge, 18111 Nordhoff Street, Northridge, CA 91330-8379; Tel: (818) 677-4613; Email: [email protected] 1. Introduction It has been argued that financing decisions made by households can depend on the environment that they live in and the social networks that they make (Hong et al., 2004; Ivković and Weisbenner, 2007; Brown et al., 2008). We look at one aspect of this sociology of financial decision-making by examining the effect of where an individual lives on their investment decisions. In particular, we examine empirically how the race of the individual interacts with the racial mixture of the surrounding neighborhood in determining the asset allocation. To do so, we use the 2007 EASI Master Database which aggregates data from the Consumer Expenditure Survey to the zip code level, and provides both demographic and financial information about the neighborhood. Previous research has found that African Americans households tend to be more conservative investors and hold smaller amounts of their financial wealth as risky assets such as stocks (Dow 2008, Choudury 2001/2002, Wang and Hanna 1997). We extend these results by showing how these racial effects depend on the racial composition of the neighborhood. In particular, we show that in predominately White neighborhoods there are significant differences in asset allocations across racial groups; however, in mixed or white minority neighborhoods, this difference disappears. In addition to looking at African American and Hispanics, we also find that Asians, a previously understudied group, show racial effects that are also neighborhood dependent, although this time the minority group shows a greater propensity to hold risky assets. Why should neighborhoods matter? Investing in risky assets, such as stocks, requires a greater level of knowledge about financial markets and investing than depositing money in3 banks, which could serve as a barrier to participation. Indeed, education has been found to be a significant factor in determining stock ownership, even when controlling for other factors (Dow 2008, Souleles 2003, Bertaut and Starr-McCleur 2000). However, formal education is not the only way to learn about investing opportunities. Observing the investing habits of others can build familiarity and comfort with financial activities outside of an individual’s background. Individuals excluded from these social networks would not have these learning opportunities available to them. To test for neighborhood effects, we first run a baseline regression that looks at the asset allocation decision for households, across all zip codes, as a function of race/ethnicity and a number of other control variables suggested by the literature on individual financial decision-making. The zip codes are then split into separate groups sorted by the percentage of the population in the zip code that is White. We run separate asset-allocation regressions for each group of zip codes and the coefficients of the regressions are then compared across the groups to see if there are statistically significant differences. Our finding, that there are differences across groups and that neighborhood composition has an effect on financial decision-making, has important practical implications. With the shift from defined benefit pension programs to defined contribution programs (such as 401(k)’s), individuals have become increasingly responsible for their own investment decisions. Because, over the long run, stocks offer higher average returns than bonds or bank accounts, households that are excessively conservative in their investing will find themselves with a smaller amount of savings on retirement. If non-financial factors, such as the social environment and the lack of awareness of investing opportunities, are leading individuals to these decisions, targeted campaigns to improve financial education may be a beneficial policy.4 2. Literature Review Campbell (2006) provides a review of various issues in household financial decision-making, including the question of how households allocate their wealth across different financial assets. In theory, a household’s willingness to hold risky assets such as stocks and corporate bonds, in contrast to less risky assets such bank accounts and low-risk bonds, depends on a number of factors. A greater tolerance for risk, either because of individual psychology or because of circumstances such as greater wealth, should lead an individual to hold more stock. In addition, factors that affect the level of comfort with relatively more sophisticated financial products such as stock could affect the household’s asset allocation. Individuals who have a better education or more familiarity with investing due to their family or cultural background may be more willing to invest in stocks and bonds. There are a number of recent papers that have investigated the asset allocation question empirically. Souleles (2003) uses the CEX to look at the effect of consumption risk on investment behavior. The dependent variable is the ratio of risky assets to consumption. He uses consumption rather than financial wealth as he argues that consumption should be a good proxy for the effect of total wealth. He finds that age has a hump-shaped effect on the share of risky assets, that education increases the holding of risky assets, and that consumption risk reduces the holding of risky assets and consumer confidence increases the holding of risky assets. Dow (2008), using data from the Survey of Consumer Finances, examines at the effect of age


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