Does portfolio diversification mitigate financial risk? Evidence from Italian survey data

In this paper we empirically show that given the positive causal relationship running from investment in risky assets to precautionary saving, portfolio diversification mitigates the effect of financial risk upon desired precautionary savings. Using a self-reported measure of desired precautionary wealth, we re-estimate the relationship between precautionary wealth and financial risk using indicators for financial literacy as instruments for the ownership of risky assets. We eventually find financial risk to be a strong determinant of precautionary accumulation. However, financial diversification helps to mitigate overall risk: households with an adequately diversified portfolio do not perceive financial risk to be a determinant of precautionary saving. Furthermore, the probability of diversifying the portfolio is estimated conditionally to the knowledge of the benefits of diversification. We eventually found that financial risk does not affect precautionary accumulation for those households who diversify their portfolio and they are aware that diversification helps to reduce overall portfolio risk. In this perspective, financial diversification helps to reduce exposure to uninsurable financial risk, thus reducing households’ need to additionally save to prevent potential financial losses.