Who Holds Risky Assets

Abstract Preference heterogeneity is a natural explanation for portfolio heterogeneity. In a dynamic environment in which preference heterogeneity is as extreme as possible, we show that intuition about the relationship between risk aversion and holdings of risky assets derived from static choice problems can be very misleading. In equilibrium, an agent with recursive utility who is infinitely risk averse over static gambles will hold a portfolio composed almost entirely of risky assets. Conversely, an agent with recursive utility who is risk neutral over static gambles will hold a portfolio composed almost entirely of risk-free assets. Moreover, there is no added compensation for holding the risky asset since equilibrium asset prices will appear to be generated by a risk-neutral representative agent. This counter-intuitive result highlights the relative roles of static risk preferences and deterministic substitution preferences in recursive utility. Since portfolio choice is fundamentally a decision about intertemporal consumption lotteries, both characteristics are important. Specifically, we show that the preference for the timing of the resolution of uncertainty plays a major role in allocation of investments between risky and risk-free assets. A strong preference for the late resolution of uncertainty translates into a strong preference for smooth consumption paths and, hence, a portfolio choice heavily skewed toward risk-free assets. This strong preference can exist even when the agent is risk neutral with respect to static gambles. Conversely, a strong preference for the early resolution of uncertainty translates into a strong preference for smooth utility which can be achieved even when portfolio choice heavily skewed toward risky assets.