Household Constraints and Financial Decisions

Abstract

We introduce debt-wealth constraints to analyze the financial decisions of typical households. Unlike an unconstrained household in normative finance, a constrained household is indebted with limited wealth. Due to binding debt repayments, a constrained household is conservative in risk tolerance and chooses not to engage risky investments or withdraws earlier than does an unconstrained unit. Empirically, we test differential financial decisions through fixed income mutual fund data. When funds deliver below-average returns, conservative investors withdraw, whereas those with aggressive risk tolerance keep risky engagements. Flows to funds with high-risk exposure are significantly larger than funds with low-risk exposure.

Keywords: Household Finance; Limited Participation in Risky Equity; Condition for Mean-Variance Optimization; Fixed-Income Mutual Fund; Fund Flows

JEL Classification: G20; G23; G28