The theoretical mean-variance efficient portfolio model was modified to incorporate human wealth and net primary residence. Eight traded assets were selected to represent the set of risky assets available to the household investors: combined stock index, large stocks, small stocks, the average return series for individual stocks in the CRSP Decile 10 (smallest) stock portfolio to proxy business ownership, corporate bonds, long-term government bonds, intermediate government bonds, and Ibbotson Associate’s real estate return series. Treasury bill represents the risk-free rate in this study. Simulation programs were developed to identify the efficient portfolios by finding the portfolio weights in risky assets that result in the minimum-variance frontier for the total portfolio. The results of the simulation programs give the efficient asset allocations to different household investors with different human wealth ratios, net primary residence ratios, and planned investment horizons, once the diversification of investment portfolios are related to the perceived stability of future employment income.
The simulation results show that when rational household investors have a high human wealth ratio (e.g., those with ages between 30 to 40 years old), and a long investment time horizon (e.g., 15 year before their retirement), their efficient frontier is a combination of intermediate government bond, real estate, large stocks, small stocks and business ownership. People with high risk aversion should invest in intermediate government bonds and real estate for a 15-year horizon. People with low risk aversion should invest in real estate, small stock funds, and business ownership for a 15-year horizon. People who have risk aversion between these two points should choose a combination in the order of intermediate government bonds, real estate, large stocks, small stocks, and business ownership.
The efficient portfolios from the simulation results are compared to the current portfolios of U.S. households estimated from the 1998 Survey of Consumer Finances. In the formal efficiency test of households’ current portfolios, about one-third of total households hold inefficient mean-variance portfolios, compared with the same characteristics as those used to produce the simulation results in this study.