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Abstract:
The proliferation of novel preference theories in financial economics is hampered by a lack of non-experimental evidence and by the theories' additional complexity which has not been shown to be critical in applications. In this paper I present arguments in support of preferences with rank dependency. Using the Survey of Consumer Finances data I document two widespread patterns inconsistent with expected utility: (i) many households simultaneously invest in well-diversified funds and in poorly-diversified portfolios of stocks; and (ii) some households with substantial savings do not invest anything in equities. I show that portfolio choice models with rank-dependent preferences, plausibly parameterized and under fully rational assumptions, are quantitatively consistent with the observed diversification. These results call for further efforts to integrate the models of rank-dependent preferences in portfolio theory and asset pricing. This paper was previously circulated under the title "Household Portfolio Diversification." The paper has benefited from the comments of Shlomo Benartzi, Luca Benzoni, Markus Brunnermeier, John Dickhaut, Maria Pirozek, Raj Singh, Hersh Shefrin, and workshop participants at Minnesota Finance bag lunch, 2003 Wharton conference "Household Financial Decision Making and Portfolio Choice", and 2003 summer meetings of Econometric Society. I would like to thank Cam Harvey (the editor) and an anonymous referee for many helpful comments and suggestions. A special thanks to Jack Kareken for comments and editorial help on an earlier draft. I am grateful to Donna Zerwitz for editorial assistance. The views expressed herein are those of the author and not necessarily of the Federal Reserve Bank of Minneapolis or the Federal Reserve System. All errors and omissions are sole responsibility of the author.

Diversification, portfolio choice, rank dependent preferences

Abstract:
In imperfect capital markets, an entrepreneur has to invest substantial personal funds to start a private firm and is forced to bear large firm-specific risk. Furthermore, if the entrepreneur is risk averse, one would expect the private equity to earn a premium for idiosyncratic risk. In this paper I explore how human capital interacts with the decision to invest in a private business and calibrate a model of entrepreneurial choice to illustrate a significant attenuating effect of human capital on the premium for firm-specific risk. When the entrepreneur can quit the business and work for hire, the firm-specific risk premium is order of magnitude lower than without this option. The main point of the model is to recognize how human capital interacts with the decision to invest in a private firm. While the entrepreneur risks a substantial fraction of her financial wealth, she does not commit all human capital to the current business. At risk is only the labor income forgone while managing the business and the rest of human capital is unaffected by the business risk. The empirical evidence suggests that private equity does not earn any significant premium over the public equity. The model with human capital is consistent with that, assuming typical entrepreneur forgoes a small return of about 1% in lieu of intangible benefits of entrepreneurship.

Human capital, private equity, entrepreneurhsip

Abstract:
This article explores the implications of additive and endogenous habit formation preferences in the context of a life-cycle model of an investor who has stochastic uninsurable labor income. To solve the model, I analytically derive the habit-wealth feasibility constraints and show that they depend on the worst possible path of future labor income and on the habit strength, but not on the probability of the worst income. When there is only a slim chance of a severe income shock, the model implies much more conservative portfolios. The model also predicts that for some low to moderately wealthy households, the portfolio share allocated to stocks increases with wealth. Because of this feature, the model can generate more conservative portfolios for younger than for middle-aged households. The effects of habits on portfolio choice are robust to income smoothing through borrowing or flexible labor supply. One controversial finding is that for high values of the habit strength parameter, usually required for the resolution of asset pricing puzzles in general equilibrium, the life-cycle model predicts counterfactually high wealth accumulation. (JEL: G11, G12)

Abstract:
This paper explores the implications of the additive and endogenous habit formation preferences in the context of a life-cycle model of an investor who has stochastic uninsurable labor income. To solve the model, I analytically derive the habit - wealth feasibility constraints and show that they depend on the worst possible path of future labor income and on the habit strength, but not on the probability of the worst income. When there is only a slim chance of a severe income shock, the model implies much more conservative portfolios. The model also predicts that for some low to moderately wealthy households, the portfolio share allocated to stocks increases with wealth. Because of this feature, the model can generate more conservative portfolios for younger than for middle-aged households. One controversial finding is that for high values of the habit strength parameter, usually required for the resolution of asset pricing puzzles in general equilibrium, the life-cycle model predicts counterfactually high wealth accumulation.

Habit formation, portfolio choice, life cycle

Abstract:
In this paper I study the implications of limited stock market participation for the equity premium. If all agents are receiving labor income and there is a small fixed cost of trading equities, then those agents with relatively low labor income choose not to participate in equity market. Because of limited risk sharing, the equity premium is higher, but only slightly higher, than in a model without frictions and full equity market participation. Thus, limited stock market participation does not resolve the equity premium puzzle.

limited stock market participation, equity premium

Abstract:
We use a calibrated life-cycle model with earnings risk and liquidity constraints to study the role of tax-deferred retirement accounts (TDAs) in life cycle savings behavior. We find that they promote higher wealth accumulation but not higher net savings. Consumption increases mostly during retirement, as desired, but the effect is largest for those households with higher savings rates already. The cost of maintaining a constant TDA contribution rate is small, but the optimal rate differs substantially across households: a "one-size-fits-all" rule does not exist. Fully exhausting employer-matching contributions, as typically recommended by financial advisors, is highly suboptimal for most households, which is consistent with the data. Moreover, employer-matching schemes actually discourage savings as the corresponding income effect dominates.

Portfolio Choice, Tax-Deferred Accounts, Retirement Savings, Liquidity Constraints, Uninsurable Labor Income Risk

Abstract:
We examine the impact of heterogeneity in preferences on asset prices in a setting where agents have rank-dependent expected utility. Endogenous limits to risk sharing arise naturally, with the more risk averse agents choosing to exit the market for the risky asset. This leads to economically significant variation in the equity premium and the risk free rate. Our results show that using a representative agent framework with non-expected utility preferences can be misleading precisely because it ignores these important endogenous risk sharing effects.

Asset Prices, Aggregation, Rank-Dependent Expected Utility

Abstract:
The expected utility model captures the attitude toward risk exclusively through the marginal utility. Recognizing this limitation several models explicitly account for aversion to downside risk. This paper presents non-experimental evidence that this feature is empirically relevant in asset pricing.

I use rank-dependent expected utility to model aversion to downside risk and derive Euler equations for consumption and asset returns. The resulting model nests the standard CCAPM and allows estimation of preferences parameters by GMM and the tests of significance of the downside risk aversion. I estimate the model using Fama and French 25 portfolios and find that it performs considerably better than the standard CCAPM. The parameter estimates imply that the left tail outcomes are over-weighted while the right tail outcomes are under-weighted. Asset prices reflect a sizable premium for downside risk and the corresponding parameter is strongly significant. The downside risk premium exhibits significant variation across the test portfolios and contributes to value and size premia.

Donwside risk, Consumption-based asset pricing, rank-dependent utility

Abstract:
The proliferation of novel preference theories in financial economics is hampered by a lack of non-experimental evidence and by the theories` additional complexity which has not been shown to be critical in applications. In this article I present arguments in support of preferences with rank dependency. Using the Survey of Consumer Finances data, I document two widespread patterns inconsistent with expected utility: (i) many households simultaneously invest in well-deversified funds and in poorly-diversified portfolios of stocks; and (ii) some households with substantial savings do not invest anything in equities. I show that portfolio choice models with rank-dependent preferences, plausibly parameterized and under fully rational assumptions, are quantitatively consistent with the observed diversification. These results call for further efforts to integrate the models of rank-dependent preferences in portfolio theory and asset pricing.

brain metastases, HRQoL, stereotactic radiosurgery

Abstract:
We calibrate a life-cycle model with uninsurable labor income risk and borrowing constraints to match wealth accumulation and portfolio allocation profiles of direct and indirect stockholders in both taxable and tax-deferred accounts. Tax-deferred accounts generate an increase in wealth accumulation that is larger for wealthier households. Furthermore, while the cost of following a fixed contribution rate over the life-cycle is small, the optimal rate can differ substantially across households, and the welfare losses from choosing the wrong one can be substantial. Finally, the welfare gain from having access to a tax-deferred account ranges from less than 0.1% to 11.5%, depending on the preference parameters.

Portfolio choice, tax-deferred accounts, retirement savings, liquidity constraints, uninsurable labor income risk