Income Risk, Borrowing Constraints and Portfolio Choice
Economic theory suggests that uninsurable income risk, health risk and the expectation of future borrowing constraints can reduce the share of risky assets in a household's portfolio. In fact, if its utility function exhibits decreasing absolute risk aversion and decreasing prudence, a household will reduce its exposure to avoidable risks when confronted with additional, independent unavoidable risks. If there are transactions costs associated with sales of illiquid and risky assets, the expectation of future borrowing constraints should induce households to keep a higher proportion of their wealth in the form of liquid and safe assets. To date, no empirical evidence has been cited in support of these theoretical claims. In this paper we use data from the 1989 Italian Survey of Household Income and Wealth to explore this issue. Using proxies for income risk, health risk and borrowing constraints, we find evidence that each of these variables significantly reduces the demand for risky assets.
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