Owner-Occupied Housing and the Composition of the Household Portfolio over the Life Cycle

The paper studies the impact of the portfolio constraint imposed by the consumption demand for housing (the “housing constraint”) on the household’s optimal holdings of financial assets. Since the ratio of housing to net worth declines as the household accumulates wealth, the housing constraint induces a life-cycle pattern in the portfolio shares of stocks and bonds. For reasonable degrees of risk aversion, the changes in portfolio composition over the life-cycle can be dramatic. For example, for a coefficient of relative risk aversion of 3, the ratio of stocks to net worth in the optimal portfolio is .09 for the youngest households (ages 18-30) and .60 for the oldest (age 70 and over). Using data from the PSID on home values to construct household level panel data on the real after-tax return to owner-occupied housing, as well as data on the returns to financial assets, the paper estimates the vector of expected returns and the covariance matrix for the set of assets consisting of housing, mortgages, stocks, Treasury bonds, and T-bills. Numerical methods are used to calculate the mean-variance efficient frontier, conditional on different values of the housing constraint, and the optimal portfolios associated with different levels of relative risk aversion. Marjorie Flavin Takashi Yamashita Department of Economics, 0508 Department of Economics, 0508 UCSD UCSD 9500 Gilman Dr. 9500 Gilman Dr. La Jolla, CA 92093-0508 La Jolla, CA 92093-0508 and NBER [email protected] [email protected] The paper uses a mean-variance efficiency framework to examine the household’s optimal portfolio problem when owner-occupied housing is included in the list of available assets. While it is straightforward to calculate the risk and return to housing, housing differs from stocks and bonds in a crucial way: since the household’s ownership of residential real estate determines the level of its consumption of housing services, the household’s demand for real estate is ‘over-determined’ in the sense that the level of real estate ownership, which is optimal from the point of view of the consumption of housing services, may differ from the optimal level of housing stocks from a portfolio point of view. In the absence of tax distortions and transactions costs, rental markets for housing would permit the household to separate its level of consumption of housing services from its investment in housing as an asset. We assume, instead, that the preferential tax treatment of owner occupied housing, and the transactions costs and agency costs involved in the rental market for housing create frictions large enough to effectively constrain households to include in their asset portfolio the level of housing consistent with their consumption demand for housing. For example, a young family will generally hold a portfolio consisting of a house worth several times their net worth, a large mortgage, and small amounts of financial assets; that is, their consumption demand for housing services causes the household to hold a larger position in real estate than they would hold on the basis of the portfolio demand for real estate. Using data from the PSID on home values to construct household level panel data on the real after-tax return to owner-occupied housing, as well as data on the returns to financial assets, the paper estimates the vector of expected returns and the covariance matrix for the set of assets consisting of housing, mortgages, stocks, Treasury bonds, and T-bills. Considering purely as an asset, the inclusion of owner-occupied housing dramatically improves the efficient frontier because the return to housing is essentially uncorrelated with the return to stocks.