Hedging, stock market participation and portfolio choice ∗ . Massimo Massa INSEAD Andrei Simonov Stockholm School of Economics January 20, 2004 Abstract We exploit the restrictions of intertemporal portfolio choice in the presence of non- financial income risk to design and implement tests of hedging that use the information contained in the actual portfolio of the investor. We use a unique dataset of Swedish in- vestors with information broken down at the investor level and into various components of wealth, investor income, tax positions and investors’ demographic characteristics. Port- folio holdings are identified at the stock level. We show that investors do not engage in hedging, but invest in stocks closely related to their non-financial income. We explain this with familiarity, that is the tendency to concentrate holdings in stocks with which the investor is familiar in terms of geographical or professional proximity or that he has held for a long period. We 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. JEL classification: G11,G14. Keywords: Asset pricing, portfolio decision, hedging. ∗ Corresponding author: M.Massa, Finance Department, INSEAD, Boulevard de Constance, 77305 Fontainebleau Cedex, France. Tel: (33)1 60 72 44 81 Fax: (33)1 60 72 40 45. Email: massimo.massa@insead.edu. We thank for helpful comments J.Campbell, J.Cocco, B.Dumas, F.Gomes, S.Livingston, M.Lettau, A.Lynch, P.Maenhout, T.Moskowitz, P.Sodini, P.Veronesi, L.Viceira, A.Vissing-Jorgenson, M.Weber and the partici- pants of the Summer Financial Markets Symposium at Gerzensee, 2003 WFA meeting and the NBER Asset Pricing Summer Institute. We are grateful to Sven-Ivan Sundqvist for numerous helpful discussions and for providing us with the data. Andrei Simonov acknowledges financial support from the Stockholm Institute for Financial Research and Jan Wallander och Tom Hedelius Stiftelse. We also thank Jean Cropper for editorial assistance. All the remaining errors are ours.