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A Theory of Portfolio Choice for Heterogeneous Investors

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  • Li, Mingzhe

Abstract

The Merton framework has difficulty explaining empirical phenomena in household finance and life-cycle patterns. This paper proposes a continuous-time heterogeneous agent model with common noise to study portfolio choice for heterogeneous investors. Households pay an "asset-exposure premium" (AEP) based on their wealth for bearing common financial risk. The AEP effect serves as a non-monotonic third term in optimal portfolio choice. For households near the borrowing constraint, the AEP effect is large and negative, overwhelming other motives and explaining limited participation. As wealth increases, the AEP effect turns positive before disappearing at high wealth, resulting in a hump-shaped profile of risky holdings. The AEP enables households to identify the risk characteristics of their portfolio, explaining why the low wealth exhibits underdiversification and why middle-to-high wealth households hold diversified portfolios. Furthermore, this paper introduces a steady state and solves the degeneration problem of the wealth distribution in the continuous-time ABH framework.

Suggested Citation

  • Li, Mingzhe, 2025. "A Theory of Portfolio Choice for Heterogeneous Investors," MPRA Paper 126642, University Library of Munich, Germany, revised 29 Oct 2025.
    • Handle: RePEc:pra:mprapa:126642
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    JEL classification:

    • C73 - Mathematical and Quantitative Methods - - Game Theory and Bargaining Theory - - - Stochastic and Dynamic Games; Evolutionary Games
    • D91 - Microeconomics - - Micro-Based Behavioral Economics - - - Role and Effects of Psychological, Emotional, Social, and Cognitive Factors on Decision Making
    • E21 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Consumption; Saving; Wealth
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions

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