Portfolio Rebalancing with Realization Utility
We develop a model where a realization-utility investor (Barberis and Xiong, 2009, 2012; Ingersoll and Jin, 2013) optimally targets her liquid-illiquid wealth ratio at a constant w∗. By saving in the risk-free asset (w∗ > 0), she makes smaller bets in the illiquid asset and realizes gains/losses more frequently. By leveraging (w∗ < 0), she makes bets larger than her equity and realizes gains/losses less frequently. For a discontinuous/jump-diffusion price process, the solution features four regions: loss-realization, gain-realization, and two disconnected (deep-loss and normal) holding regions. We generate a quantitatively significant non-monotonic propensity to realize losses consistent with evidence.
We thank Nick Barberis, Patrick Bolton, Kent Daniel, Bing Han, Xuedong He, David Hirshleifer, Harrison Hong, Michaela Pagel, Cameron Peng, Tom Sargent, Wei Xiong, Liyan Yang, and seminar participants at Columbia for helpful comments. The views expressed herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research.