Portfolio Choice in the Presence of Background Risk

Abstract

In this paper, we focus on how the presence of background risks ± from sources such as labour and entrepreneurial income ± in¯uences portfolio allocations. This interaction is explored in a theoretical model that is calibrated using cross-sectional data from a variety of sources. The model is shown to be consistent with some but not all aspects of cross-sectional observations of portfolio holdings. The paper also provides a survey of the extensive theoretical and empirical literature on portfolio choice.

Entry costs and stock market participation over the life cycle

“…Heaton and Lucas (2000a) find a positive significant correlation between stock returns and intrapreneurial income (around 0.2) but small and insignificant values for other occupation groups. Estimates obtained by Davis and Willen (2000) range between 0.1 to 0.3 for a college educated group and significantly negative for a lower education group.…”

Trust and the Choice Between Housing and Financial Assets: Evidence from Spanish Households*

“…The reason is that the return may be affected by (mis)behavior of other parties. As a consequence, trust in others matters for the subjective expected return, and less trustful individuals hold fewer 1 Other explanations of limited stock market participation that have been advanced are the presence of background risk (Heaton and Lucas 2000), non-standard preferences (Barberis, Huang and Santos 2001), fixed entry costs (Vissing-Jorgensen 2002), learning costs (Bayer, Bernheim andScholz 2009, Bernheim andGarrett 2003) and the cost of awareness (Guiso and Japelli 2005). All of these papers consider financial assets only.…”

Robustly Strategic Consumption–Portfolio Rules with Informational Frictions

“…The key reason for using a state-dependent counterpart ϑ t in Maenhout (2004) is to assure the homotheticity or scale invariance of the decision problem with the CRRA utility function. 23 In this paper, we also specify that ϑ t is state-dependent (ϑ (s t )) in the CARA-Gaussian setting. The main reason for this specification is to guarantee homotheticity, which makes robustness not diminish as the value of the total wealth increases.…”

“…See AHS (2003) and Hansen, Sargent, Turmuhambetova, and Williams (2006) (henceforth, HSTW) for detailed discussions on these two robustness specifications. 23 See Maenhout (2004) for detailed discussions on the appealing features of "homothetic robustness". 24 Note that the impact of robustness wears off if we assume that ϑ t is constant.…”

“…2 The recent empirical evidence on household portfolios in the U.S. and major European countries has also stimulated research in generalizing the single asset precautionary saving model to allow for portfolio choice between risky and risk-free financial assets. 3 For example, Heaton and Lucas (2000) studied how the presence of background risks influences portfolio allocations. They found that labor income is the most important source of wealth and labor income risk is weakly positively correlated with equity returns.…”