Asset Selection and Under-Diversification with Financial Constraints and Income : Implications for Household Portfolio Studies

Household portfolio empirical studies have shown that young and relatively poor households hold under-diversified portfolios that are concentrated in a small number of assets, a fact often attributed to various behavioral biases. We present a model that offers a rational potential alternative: we show that relatively poor investors, i.e., investors with little financial wealth, who receive a stable labor income and have access to multiple risky assets rationally limit the number of assets they invest in when faced with financial constraints such as margin requirements and restrictions on borrowing. We provide both theoretical and numerical support for our results and show, in an example calibrated to returns of five industry portfolios from 1927-2004, that while older investors optimally hold diversified portfolios, younger investors with stable labor income prefer portfolios that are concetrated in high-tech stocks that offer higher expected returns. Our results suggest that the ratio of financial wealth to labor income would be a useful control variable in household portfolio studies