Recent theoretical models predict that a rise in uninsurable income risk or the expectation of future borrowing constraints reduces consumers' willingness to bear rate-of-return risk and their demand for risky securities, but difficulties in measuring the subjective uncertainty of future income fluctuations have impeded empirical research. In Discussion Paper No. 888, Luigi Guiso, Research Fellow Tullio Jappelli and Daniele Terlizzese investigate these effects using data on (subjective) responses to Italy's 1989 Survey of Income and Wealth and information on credit status in the 1987 Survey with which they construct proxies for the probability of liquidity constraints in the 1989 cross-section. In a two-period model, consumers can invest in `safe' or `risky' assets; their second-period incomes are distributed independently of the return on the risky asset, but they cannot insure against income risk. `Risky' assets are broadly defined to include savings accounts, private financial assets and government paper (on which there is a risk of default); `safe' assets are defined residually as cash, current accounts and postal deposits. They also consider a narrower definition of risky assets to include only long-term government bonds, corporate bonds, investment fund units and equities.

Risky assets account for 58.4% or 16.2% of total financial assets depending on the choice of definition, but the corresponding average shares in households' portfolios are only 33.1% and 4.6%, which reflects the skewness of their distribution. These low shares may reflect high transaction costs and information costs associated with the purchase and sale of risky assets or some households' choosing to reduce their exposure to avoidable risk of holding such securities when confronted with unavoidable risk to income. The authors regress the shares of risky assets on demographic variables and proxies for initial endowments, income risk and borrowing constraints to show that income risk and borrowing constraints play important roles in Italian households' portfolio allocation. Removing borrowing constraints could raise the share of risky assets by 4.9%, while eliminating income uncertainty could raise it by between 1.5% and 6%.

Income Risk, Borrowing Constraints and Portfolio Choice
Luigi Guiso, Tullio Jappelli and Daniele Terlizzese

Discussion Paper No. 888, January 1994 (IM)