on an Investor’s Portfolio Choice?

Stocks are exposed to the risk of sudden downward jumps, and a crash in one stock (or index) may increase the risk of a crash for other stocks (or indices). This may have a crucial impact on investors ’ portfolio choices, since it reduces their ability to diversify their portfolios. Allowing the economy to be in either of two regimes (calm, contagion), we explicitly take contagion risk into account and study its impact on the portfolio decision of a CRRA investor both in a complete and in an incomplete market. We find that the investor significantly adjusts his portfolio when contagion is more likely to occur. Capturing the time dimension of contagion, i.e. the time difference between the downward jump in the first and in the second stock, is thus of first-order importance when analyzing portfolio decisions. An investor ignoring contagion completely or accounting for contagion while ignoring its time dimension suffers a large and economically significant utility loss. This loss is larger in a complete than in an incomplete market, and the investor might be better off if he does not trade derivatives at all