Modelling the composition of household portfolios: a latent class approach

We introduce the latent class modelling approach to the analysis of financial portfolio diversification at the household level. We explore portfolio allocation in Great Britain using household panel data based on a nationally representative sample of the population, namely the Wealth and Assets Survey. The latent class aspect of the model splits households into four groups, which serves to unveil a more detailed picture of the determinants of portfolio diversification than existing econometric approaches. Our findings reveal a pattern of class heterogeneity that conventional econometric models are unable to identify as the statistical significance as well as the direction of the effect of some explanatory variables varies across the four classes. When comparing our preferred latent class estimator to the commonly used approaches, we find that treating the population as a single homogeneous group may lead to biased parameter estimates and suggests that policy based on such models could be inappropriate or erroneous.