Investor Sophistication and the Home Bias, Diversification, and Employer Stock Puzzles

Abstract

Using data from the April 2005 Survey of Consumers, we develop an index of investor sophistication from a set of 14 quiz-like questions. We correlate our measure of sophistication with holdings of international investments, measures of diversification, and holdings of an employer's stock. We find that each of these variables is correlated with sophistication, with more sophisticated investors consistently behaving the way that financial economists would recommend. More sophisticated investors also appear more likely to participate in the stock market. We argue that since sophistication is correlated with each of these anomalous behaviors, the most likely explanation for each behavior is that unknowledgable investors simply make mistakes.