There are dramatic differences in flexibility between investments such as real estate and financial instruments such as stocks, bonds and mutual funds. Beyond the investments themselves, rules of organizations that manage them and tax rules affect the flexibility of investments.
To examine the flexibility concept, we consider a two-period model. We investigate the hypothesis that the greater the investor’s flexibility, i.e., the easier it is for him to change his portfolio depending on his period one results, the more willing he is to accept risks at the outset. If true, there will be significant implications for policy. For example, the 1997 capital gains tax cut would assuredly promote risk taking investment, and annuity managers who facilitate switches for their policy holders between stockholdings and bondholdings will experience a long-run tilt toward stocks.
Flexibility will assure greater risk taking only in some special cases; for example, if the investor must choose in period one between a riskless investment and a specified risky investment. It also works for the standard portfolio problem when relative risk aversion is less than unity. However, in the more general context where there are a number of risky potential investments, flexibility may actually diminish risk taking. This suggests that how and when flexibility promotes risk taking is a subject meriting empirical study.
This paper was published in the Journal of Economic Theory, Vol. 76, No. 2, October 1997.
