Cambridge Journals Online

MARKET FRICTIONS, SAVINGS BEHAVIOR, AND PORTFOLIO CHOICE

We examine a decision theoretic model of portfolio choice in which investors face income risk that is not directly insurable. We consider the sensitivity of savings and portfolio allocation rules to different assumptions about utility, the stochastic process for income and asset returns, and market frictions (transactions costs and short-sale constraints). Under CRRA time additive utility, habit persistence utility, and for a broad range of parameterizations, the model predicts that investors wish to borrow and invest all of their savings in stocks. This qualitative implication is robust to the introduction of significant transaction costs in the stock market, and contrasts sharply with portfolio allocation models in which there is no labor income.

Footnotes

¹ We thank George Constantinides, Pamela Labadie, and seminar participants at Berkeley, the Federal Reserve Board, London Business School, New York University, Ohio State, Stanford, the University of Wisconsin, Washington University, and the NBER Summer Institute for helpful suggestions. We also thank the National Science Foundation and the Sloan Foundation (Heaton) for financial support.