Using only the definition of returns, together with a transversality assumption, we demonstrate that given a dividend process, any one of three variables—expected return, return volatility, and the price–dividend ratio—completely determines the other two. By parameterizing only one of these processes, common empirical specifications place strong, and sometimes counter-factual, restrictions on the dynamics of the other variables. Our findings lend insight into the nature of the risk–return relation and the predictability of stock returns.

Many firms have stockholders who face severe restrictions on their ability to sell their shares and diversify the risk of their personal wealth. We study the costs of these liquidity restrictions on stockholders using a continuous-time portfolio choice framework. These restrictions have major effects on the optimal investment and consumption strategies because of the need to hedge the illiquid stock position and smooth consumption in anticipation of the eventual lapse of the restrictions. These results provide a number of important insights about the effects of illiquidity in financial markets.

We provide a formal treatment of both static and dynamic portfolio choice using the Disappointment Aversion preferences of Gul (1991. Econometrica 59(3), 667–686), which imply asymmetric aversion to gains versus losses. Our dynamic formulation nests the standard CRRA asset allocation problem as a special case. Using realistic data generating processes, we find reasonable equity portfolio allocations for disappointment averse investors with utility functions exhibiting low curvature. Moderate variation in parameters can robustly generate substantial cross-sectional variation in portfolio holdings, including optimal non-participation in the stock market.