Hedging, Familiarity and Portfolio Choice

The authors exploit the restrictions of intertemporal portfolio choice in the presence of nonfinancial income risk to test hedging using the information contained in the actual portfolio of the investor. The authors use a unique dataset of Swedish investors with information broken down at the investor level and into various components of investor wealth, income, and demographic characteristics. Portfolio holdings are identified at the stock level. The authors show that investors do not hedge but invest in stocks closely related to their nonfinancial income. They explain this with familiarity, that is, the tendency to concentrate holdings in stocks to which the investor is geographically or professionally close or that he has held for a long period. The authors show that familiarity is not a behavioral bias, but is information driven. Familiarity-based investment allows investors to earn higher returns than they would have otherwise earned if they had hedged.