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Optimal life-cycle asset allocation: understanding the empirical evidence

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  • Francisco Gomes
  • Alexander Michaelides
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    Abstract

    We show that a life-cycle model with realistically calibrated uninsurable labor income risk and moderate risk aversion can simultaneously match stock market participation rates and asset allocation decisions conditional on participation. The key ingredients of the model are Epstein-Zin preferences, a fixed stock market entry cost, and moderate heterogeneity in risk aversion. Households with low risk aversion smooth earnings shocks with a small buffer stock of assets and consequently most of them (optimally) never invest in equities. Therefore, the marginal stockholders are (endogenously) more risk-averse and as a result they do not invest their portfolios fully in stocks.

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    File URL: http://eprints.lse.ac.uk/24900/
    File Function: Open access version.
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    Bibliographic Info

    Paper provided by London School of Economics and Political Science, LSE Library in its series LSE Research Online Documents on Economics with number 24900.

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    Length: 55 pages
    Date of creation: Nov 2003
    Date of revision:
    Handle: RePEc:ehl:lserod:24900

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    Web page: http://www.lse.ac.uk/
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    Related research

    Keywords: Life-cycle models; Portfolio choice; Preference heterogeneity; Liquidity constraints; Stock market participation; Uninsurable labor income risk;

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    References

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    1. Heaton, John & Lucas, Deborah J, 1996. "Evaluating the Effects of Incomplete Markets on Risk Sharing and Asset Pricing," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 104(3), pages 443-87, June.
    2. Gourinchas, Pierre-Olivier & Parker, Jonathan A, 2000. "Consumption Over the Life-Cycle," CEPR Discussion Papers 2345, C.E.P.R. Discussion Papers.
    3. James M. Poterba & Andrew Samwick, 2001. "Household Portfolio Allocation over the Life Cycle," NBER Chapters, in: Aging Issues in the United States and Japan, pages 65-104 National Bureau of Economic Research, Inc.
    4. John Y. Campbell & Luis M. Viceira, 1996. "Consumption and Portfolio Decisions When Expected Returns are Time Varying," NBER Working Papers 5857, National Bureau of Economic Research, Inc.
    5. Hyeng Keun Koo, 1998. "Consumption and Portfolio Selection with Labor Income: A Continuous Time Approach," Mathematical Finance, Wiley Blackwell, Wiley Blackwell, vol. 8(1), pages 49-65.
    6. Bertaut, Carol C. & Haliassos, Michael, 1997. "Precautionary portfolio behavior from a life-cycle perspective," Journal of Economic Dynamics and Control, Elsevier, Elsevier, vol. 21(8-9), pages 1511-1542, June.
    7. Erzo G. J. Luttmer, 1999. "What Level of Fixed Costs Can Reconcile Consumption and Stock Returns?," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 107(5), pages 969-997, October.
    8. S Rao Aiyagari & Mark Gertler, 1997. "Asset Returns with transaction costs and uninsured individual risk," Levine's Working Paper Archive 648, David K. Levine.
    9. George M. Constantinides & John B. Donaldson & Rajnish Mehra, . "Junior Can't borrow: A New Perspective on the Equity Premium Puzzle."," CRSP working papers 457, Center for Research in Security Prices, Graduate School of Business, University of Chicago.
    10. John Heaton & Deborah Lucas, 2000. "Portfolio Choice and Asset Prices: The Importance of Entrepreneurial Risk," Journal of Finance, American Finance Association, American Finance Association, vol. 55(3), pages 1163-1198, 06.
    11. Orazio Attanasio & James Banks & Sarah Tanner, 1998. "Asset Holding and Consumption Volatility," NBER Working Papers 6567, National Bureau of Economic Research, Inc.
    12. Christopher D Carroll, 1990. "Buffer-Stock Saving and the Life Cycle/Permanent Income Hypothesis," Economics Working Paper Archive 371, The Johns Hopkins University,Department of Economics, revised Aug 1996.
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    14. He, Hua & Modest, David M, 1995. "Market Frictions and Consumption-Based Asset Pricing," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 103(1), pages 94-117, February.
    15. Cagetti, Marco, 2003. "Wealth Accumulation over the Life Cycle and Precautionary Savings," Journal of Business & Economic Statistics, American Statistical Association, American Statistical Association, vol. 21(3), pages 339-53, July.
    16. Jonathan Skinner & Stephen P. Zeldes, 2002. "The Importance of Bequests and Life-Cycle Saving in Capital Accumulation: A New Answer," American Economic Review, American Economic Association, vol. 92(2), pages 274-278, May.
    17. Lucas, Deborah J., 1994. "Asset pricing with undiversifiable income risk and short sales constraints: Deepening the equity premium puzzle," Journal of Monetary Economics, Elsevier, Elsevier, vol. 34(3), pages 325-341, December.
    18. Constantinides, George M, 1986. "Capital Market Equilibrium with Transaction Costs," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 94(4), pages 842-62, August.
    19. Epstein, Larry G & Zin, Stanley E, 1989. "Substitution, Risk Aversion, and the Temporal Behavior of Consumption and Asset Returns: A Theoretical Framework," Econometrica, Econometric Society, Econometric Society, vol. 57(4), pages 937-69, July.
    20. King, Mervyn A. & Leape, Jonathan I., 1998. "Wealth and portfolio composition: Theory and evidence," Journal of Public Economics, Elsevier, vol. 69(2), pages 155-193, June.
    21. Luis M. Viceira, 2001. "Optimal Portfolio Choice for Long-Horizon Investors with Nontradable Labor Income," Journal of Finance, American Finance Association, American Finance Association, vol. 56(2), pages 433-470, 04.
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    Cited by:
    1. Polkovnichenko, Valery, 2004. "Limited stock market participation and the equity premium," Finance Research Letters, Elsevier, Elsevier, vol. 1(1), pages 24-34, March.

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