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Portfolio Choice in the Presence of Personal Illiquid Projects

  • Miquel Faig
  • Pauline Shum

Personal projects, such as a private business or the purchase of a home, influence portfolio choice in two ways. First, financial assets can be used to provide diversification against bad outcomes of personal projects. Second, financial assets can be used to provide liquidity to personal projects when these projects are illiquid and individuals have a limited debt capacity. The latter interaction is the focus of our paper. Due to this liquidity consideration, individuals are more risk averse if there is a large penalty for discontinuing or under-investing in the final stages of a project. A large penalty arises when there is strong complementarity between investments at dierent stages, or in projects that require lumpy investments. We provide a theoretical analysis and an empirical investigation of these eects. Using data from the 1995 Survey of Consumer Finances, we show that, consistent with our hypotheses, households which are saving to invest in their own businesses or in their own homes have significantly safer financial portfolios. The impact of the first category is particularly strong. Our findings also help explain why households, in particular younger ones, have larger than expected holdings of safe financial assets.

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Paper provided by University of Toronto, Department of Economics in its series Working Papers with number faig-00-03.

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Length: 27 pages
Date of creation: 11 May 2000
Date of revision:
Handle: RePEc:tor:tecipa:faig-00-03
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  1. S Rao Aiyagari & Mark Gertler, 1997. "Asset Returns with transaction costs and uninsured individual risk," Levine's Working Paper Archive 648, David K. Levine.
  2. George M. Constantinidies & John B. Donaldson & Rajnish Mehra, 1998. "Junior Can't Borrow: A New Perspective on the Equity Premium Puzzle," NBER Working Papers 6617, National Bureau of Economic Research, Inc.
  3. Ravi Jagannathan & Narayana R. Kocherlakota, 1996. "Why should older people invest less in stock than younger people?," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Sum, pages 11-23.
  4. Heaton, John & Lucas, Deborah, 1997. "Market Frictions, Savings Behavior, And Portfolio Choice," Macroeconomic Dynamics, Cambridge University Press, vol. 1(01), pages 76-101, January.
  5. Narayana R. Kocherlakota, 1996. "The Equity Premium: It's Still a Puzzle," Journal of Economic Literature, American Economic Association, vol. 34(1), pages 42-71, March.
  6. Aiyagari, S. Rao & Gertler, Mark, 1990. "Asset Returns With Transactions Costs And Uninsured Individual Risk: A Stage Iii Exercise," Working Papers 90-43, C.V. Starr Center for Applied Economics, New York University.
  7. Bengt Holmstrom & Jean Tirole, 1998. "LAPM: A Liquidity Based Asset Pricing Model," Working papers 98-8, Massachusetts Institute of Technology (MIT), Department of Economics.
  8. Froot, Kenneth A & Scharfstein, David S & Stein, Jeremy C, 1993. " Risk Management: Coordinating Corporate Investment and Financing Policies," Journal of Finance, American Finance Association, vol. 48(5), pages 1629-58, December.
  9. Heaton, John & Lucas, Deborah J, 1996. "Evaluating the Effects of Incomplete Markets on Risk Sharing and Asset Pricing," Journal of Political Economy, University of Chicago Press, vol. 104(3), pages 443-87, June.
  10. Philippe Weil, 1992. "Equilibrium Asset Prices With Undiversifiable Labor Income Risk," NBER Working Papers 3975, National Bureau of Economic Research, Inc.
  11. Hyeng Keun Koo, 1998. "Consumption and Portfolio Selection with Labor Income: A Continuous Time Approach," Mathematical Finance, Wiley Blackwell, vol. 8(1), pages 49-65.
  12. John Heaton & Deborah Lucas, 2000. "Portfolio Choice and Asset Prices: The Importance of Entrepreneurial Risk," Journal of Finance, American Finance Association, vol. 55(3), pages 1163-1198, 06.
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