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We characterize and measure a long-run risk return tradeoff for the valuation of financial cash flows that are exposed to fluctuations in macroeconomic growth. This tradeoff features components of financial cash flows that are only realized far into the future but are still reflected in current asset values. We use the recursive utility model with empirical inputs from vector autoregressions to quantify this relationship; and we study the long-run risk differences in aggregate securities and in portfolios constructed based on the ration of book equity to market equity. Finally, we explore the resulting measurement challenges and the implied sensitivity to alternative specifications of stochastic growth.

Using cross-sectional data from the SCF and Tax Model, we show that entrepreneurial income risk has a significant inf luence on portfolio choice and asset prices. We find that households with high and variable business income hold less wealth in stocks than other similarly wealthy households, although they constitute a significant fraction of the stockholding population. Similarly for nonentrepreneurs, holding stock in the firm where one works reduces the portfolio share of other common stocks. Finally, we show that adding proprietary income to a linear asset pricing model improves its performance over a similar model that includes only wage income.IN CONSTRUCTING INVESTMENT PORTFOLIOS, it appears that many if not most households fail to behave in a manner consistent with simple economic theory. Even among relatively wealthy households, the share of financial assets held in different asset classes varies widely, and there is evidence that among those who hold common stock, there is often little diversification~e.g., King and Leape~1987!, Blume and Zeldes~1994!!. We begin this paper with an empirical investigation into some of the risk factors and demographic variables that might explain these cross-sectional differences in portfolio composition. A number of previous studies focus on the level and variability of wage income growth as one of the largest sources of undiversifiable income risk. Here we present evidence that, for the subset of the population that has significant stockholdings, income from entrepreneurial ventures~which we refer to as proprietary business income) represents a large source of undiversifiable risk that is more highly correlated with common stock returns. These findings motivate the investigation in the second part of the paper of a linear asset pricing model that incorporates proprietary income from privately held businesses as a risk factor.

In this paper, we focus on how the presence of background risks ± from sources such as labour and entrepreneurial income ± in¯uences portfolio allocations. This interaction is explored in a theoretical model that is calibrated using cross-sectional data from a variety of sources. The model is shown to be consistent with some but not all aspects of cross-sectional observations of portfolio holdings. The paper also provides a survey of the extensive theoretical and empirical literature on portfolio choice.