Ambiguity aversion and the puzzle of own-company stock in pension plans

Finance

IFA Working Paper

2003

In a defined contribution pension plan, employees make the investment decisions since they ultimately bear the investment risks. It has been shown empirically that, whenever the firm's own stock is one of the available assets, many employees invest a significant fraction of their discretionary contributions in the stock of their employer. Moreover, the proportion allocated to own-company stock increases as the volatility of the company's stock decreases. We analyse this puzzle using a framework based on ambiguity aversion when making decisions in the presence of model misspecification. Using this framework we derive a simple model where agents hold own company stock in equilibirum. Our calibration results indicate that if the investor thinks that the expected return on own-company stock will outperform other firms in the market by just 1% to 2%, then this will lead to an investment in own-company stock of about 20% to 30%.

Institute of Finance and Accounting

FIN 390

IFA Working Paper

No