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RFS Advance Access originally published online on March 26, 2004
Review of Financial Studies 2005 18(1):197-239; doi:10.1093/rfs/hhh007
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The Review of Financial Studies Vol. 18, No. 1 © 2005 The Society for Financial Studies; all rights reserved.

Optimal Consumption and Portfolio Choices with Risky Housing and Borrowing Constraints

Rui Yao
Baruch College, City University of New York

Harold H. Zhang
The University of North Carolina at Chapel Hill

Address correspondence to: Harold Zhang, Kenan-Flagler Business School, The University of North Carolina at Chapel Hill, Chapel Hill, NC 27599, or e-mail: zhangha{at}kenan-flagler.unc.edu.

We examine the optimal dynamic portfolio decisions for investors who acquire housing services from either renting or owning a house. Our results show that when indifferent between owning and renting, investors owning a house hold a lower equity proportion in their net worth (bonds, stocks, and home equity), reflecting the substitution effect, yet hold a higher equity proportion in their liquid portfolios (bonds and stocks), reflecting the diversification effect. Furthermore, following the suboptimal policy of always renting leads investors to overweigh in stocks, while following the suboptimal policy of always owning a house causes investors to underweigh in stocks.


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