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MARKET FRICTIONS, SAVINGS BEHAVIOR, AND PORTFOLIO CHOICE

Published online by Cambridge University Press:  02 March 2005

JOHN HEATON
Affiliation:
Kellogg Graduate School of Management, Northwestern University and National Bureau of Economic Research
DEBORAH LUCAS
Affiliation:
Kellogg Graduate School of Management, Northwestern University and National Bureau of Economic Research

Extract

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.

Type
Research Article
Copyright
© 1997 Cambridge University Press

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