The effect of real estate investment on asset allocation of risky assets for individuals

Abstract

This dissertation investigates the optimal portfolio allocation by integrating the concept of real estate, human capital and risk tolerance. Different from the traditional approach, this dissertation improves the conventional asset allocation analysis by quantifying the effects of real estate and human capital on personal asset allocation. Home purchase is the most important investment decision for households. It constitutes a major portion of individuals' investment and real estate acts as both consumption good and investment good. Moreover, labor income is the valuable assets for all individuals. It can be seen as a dividend on the individuals' implicit holding of human wealth. But future labor income is uncertain and this uncertainty can diversify the portfolio risk. In addition, the investors can increase their labor supply in order to provide a buffer for poor performance in stock markets. A numerical model for optimal asset allocation developed by Chan and Viceira (2000) is employed in this essay. Some adjustments are made in order to examine the impacts of real estate and human capital on portfolio allocation. The results indicate that higher the risk tolerance level will lead to higher holdings in risky assets. Also, the effect of risk tolerance is strengthened when the investment horizon increases. For labor supply flexibility, its impact is more obvious when the investors have longer investment horizon. Besides, real estate plays an important role in asset allocation. As the outstanding balance of the mortgage decreases, investors will increase their investment in risky assets. Furthermore, by increasing the weighting in risk estate, the optimal allocation for the Hong Kong investors initially increases and decreases afterward. In contrast, the optimal percentage of US risky assets decreases as the weighting in real estate increases. By employing the regression models, it illustrates that risk tolerance and real estate directly affect the optimal asset allocation. Some demographic variables have significant impact on both risk tolerance level and the optimal asset allocation. Financial planners should consider all these factors during formulating the investment strategies. Hence, they can provide better services for their clients.