Portfolio Choice in the Presence of Personal Illiquid Projects

Abstract

Personal projects, such as a private business or the purchase of a home, inf luence individuals' portfolio choice. We conduct a theoretical analysis of this inf luence when financial assets are required to provide liquidity to personal projects. Due to this liquidity consideration, individuals behave in a more risk-averse fashion when there is a large penalty for discontinuing or underinvesting in the final stages of the projects. In addition, using data from the 1995 Survey of Consumer Finances, we find that households that are saving to invest in their own businesses or in their own homes indeed have significantly safer financial portfolios.A LARGE PORTION OF PRIVATE ASSETS are invested in personal illiquid projects. These are projects that must be partly self-financed and are costly to sell. According to the 1995 Survey of Consumer Finances~SCF!, residential housing and capital invested in unincorporated businesses account for 41.2 percent and 19.1 percent, respectively, of household wealth. 1 In this paper, we study the impact of these personal illiquid projects on individuals' portfolios of financial assets. Personal projects inf luence portfolio choice in two ways. First, financial assets can be used to provide diversification against bad outcomes of personal projects. This interaction is well recognized in the literature as it emanates from standard portfolio theory. Second, financial assets can be used to provide liquidity to personal projects when the timing of investment in these projects is important. This latter interaction is the focus of our paper. We show that it helps explain why individuals, particularly young investors and entrepreneurs, have larger than expected holdings of safe financial assets.In the financial planning literature, young investors are advised to hold a larger share of risky assets in their financial portfolios in order to capture the superior expected return of these assets. As investors grow older, they are advised to gradually reduce their holdings of risky assets. Jagannathan and Kocherlakota~1996! show that this advice is economically sound as long as the investor's human wealth is relatively uncorrelated with stock returns.

What explains household stock holdings?

“…In our earlier paper (Faig and Shum, 2002), we show that the lumpiness and illiquidity of private investment projects change in surprising ways the risk taking behavior in the portfolio of financial assets. More generally, liquidity considerations and the lumpiness of many expenditures should affect the incentives for accepting risks in the financial portfolio in ways that we should strive to understand better.…”

“…The latter is a proxy for entrepreneurial risk (Heaton and Lucas, 2000), and is also an example of personal illiquid projects that generate liquidity needs (Faig and Shum, 2002). We use private business value (which includes personal assets used as collateral for business loans) relative to total net worth as a proxy for these effects.…”

“…15 The main difference between our empirical framework and theirs is the set of explanatory variables. While Ameriks and Zeldes focus exclusively on age and time in their regressions, we include a wide range of household characteristics in ours.…”

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

“…; see e.g. Cuoco and Liu (2000), Flavin and Yamashita (2002), Faig and Shum (2002), Cocco (2004), Hu (2005) and Yao and Zhang (2005). While these models are much richer than the one we use, none of these papers analyzes the role of trust.…”

Mortgage Debt and Entrepreneurship

“…We also extend our framework to consider the case where these advantages 1 In a similar vein, Heaton and Lucas (2000) show that entrepreneurs invest proportionally less in stocks than other dependent workers. Faig and Shum (2002) bring together housing and entrepreneurial ventures in their analysis and demonstrate that households who plan to invest in one of these two activities, which they call 'illiquid projects', hold significantly safer portfolios. This conclusion is consistent with the insights of Henderson and Ioannides (1983) and Brueckner (1997) who show that homeowners cannot adequately diversify their portfolio when the investment constraint induced by owner-occupied housing is binding.…”