The Welfare Cost of Ignoring the Beta

Because of risk aversion, any sensible investment valuation system should value less projects that contribute more to aggregate risk. But most public institutions use a discount rate that is insensitive to the risk profile of their investment projects. To measure the welfare loss of this rule, I calibrate a Lucas model that matches the traditional financial and macro moments, together with the observed heterogeneity of assets’ risk profiles. The welfare loss of using a single discount rate is equivalent to a permanent reduction in consumption that lies somewhere between 15% and 45% depending on which single discount rate is used.