We offer a rational explanation for the observed under-diversification of household portfolios in a complete market, partial equilibrium setting with an investor with CRRA preferences, whose investment opportunity set includes both a riskless asset and multiple risky assets, and who receives an income stream. We show that when the investor faces a margin requirement based on his current wealth, he shifts his portfolio towards undiversified portfolios with fewer assets that offer higher expected returns. We identify the ratio of financial wealth to financial wealth augmented by discounted lifetime labor income as the variable that governs the investor's behavior. We also consider the general equilibrium cross-sectional implications of margin requirements in an overlapping-generations model.
Joint with Herve Roche