IN THE CASES that we have analyzed thus far, investors exhibited substantial diversity. They held different initial portfolios and had different marginal utility functions. On the other hand, they were alike in a number of respects. Most important, they all agreed on the probabilities of future states of the world. Moreover, none had sources of consumption outside the financial markets. Finally, none favored any future state over another—more specifically, for each investor the marginal utilities of consumption in future states with the same consumption were the same.
In this chapter, we investigate cases in which investors are more diverse. First, we consider the impact of outside sources of consumption, which we term investors' positions. Then we examine the possible impact of differences in investor's preferences for consumption in different possible states of the world— differences that may also reflect the influence of outside positions, broadly construed. As before, we retain the assumption that all investors agree on the probabilities of future states of the world, leaving for Chapter 6 the analysis of the possible effects of disagreement concerning future prospects.
For most people, investments are only one source of consumption. Other sources include wage and salary income and consumption obtained from durable goods and physical assets such as owner-occupied housing. To keep matters simple we will divide all non-investment sources of consumption into two categories: salary and collateral. Collateral includes items such as houses and cars that can be pledged to borrow money and to take other positions that require payments in some or all future states of the world. Salary cannot be used in this way, primarily because of bankruptcy laws. In many countries if one's debts exceed one's assets it is possible to declare bankruptcy, default on debts that exceed one's asset value, and keep income from subsequent labor services.
Of course there are gray areas. People can take some uncollateralized loans, since bankruptcy may involve social stigma, difficulty in obtaining future credit, and so on. The cost of borrowing may also be greater the greater a person's debt as a percentage of the value of assets posted as collateral. But these aspects can