Income Risk, Borrowing Constraints, and Portfolio Choice.

Economic theory suggests that uninsurable income risk and the expectation of future borrowing constraints can reduce the share of risky assets in a household's portfolio. If the utility function exhibits decreasing absolute risk aversion and decreasing prudence, an individual will reduce his exposure to rate-of-return risks when confronted with other independent risks. If there are transaction costs, the expectation of future borrowing constraints should induce individuals to keep a lower proportion of their wealth in the form of illiquid and risky assets. The authors find support for these propositions in a cross-section of Italian households. Copyright 1996 by American Economic Association.