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Does Relative Risk Aversion Vary with Wealth? Evidence from Households' Portfolio Choice Data

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  • Fang Yang

    ()

  • Xuan Liu

    ()

  • Zongwu Cai

    ()

Abstract

In this article, we explore whether relative risk aversion varies with wealth. First, we derive theoretical predictions on how risky shares respond to wealth uctuations in a portfolio choice model with both external habits and time-varying labor income. Our analytical results indicate that: (1) for each household, there are two channels through which the risky share responds to wealth uctuations, the habit channel and the income channel; (2) across households, there are heterogeneous responses through the habit channel: those who experience large negative income shocks reduce their share of risky assets; and (3) two potential mis-identi cation problems arise when both the heterogeneity in responses through the habit channel and the income channel are ignored. We then test the theoretical predictions with data from the Panel Study of Income Dynamics. Contrary to the existing literature, our empirical ndings show evidences of relative risk aversion varying with wealth over time after correcting those two mis-identi cation problems.

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Bibliographic Info

Paper provided by Department of Economics, Louisiana State University in its series Departmental Working Papers with number 2013-09.

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Handle: RePEc:lsu:lsuwpp:2013-09

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  1. Jessica A. Wachter & Motohiro Yogo, 2010. "Why Do Household Portfolio Shares Rise in Wealth?," Review of Financial Studies, Society for Financial Studies, vol. 23(11), pages 3929-3965, November.
  2. Pierre‐André Chiappori & Monica Paiella, 2011. "Relative Risk Aversion Is Constant: Evidence From Panel Data," Journal of the European Economic Association, European Economic Association, vol. 9(6), pages 1021-1052, December.
  3. Karen E. Dynan, 2000. "Habit Formation in Consumer Preferences: Evidence from Panel Data," American Economic Review, American Economic Association, vol. 90(3), pages 391-406, June.
  4. Michele Boldrin & Lawrence J. Christiano & Jonas D.M. Fisher, 1999. "Habit persistence, asset returns and the business cycles," Working Paper Series WP-99-14, Federal Reserve Bank of Chicago.
  5. Cochrane, John H. & Campbell, John, 1999. "By Force of Habit: A Consumption-Based Explanation of Aggregate Stock Market Behavior," Scholarly Articles 3119444, Harvard University Department of Economics.
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  8. Laurent E. Calvet & John Y. Campbell & Paolo Sodini, 2008. "Fight or Flight? Portfolio Rebalancing by Individual Investors," NBER Working Papers 14177, National Bureau of Economic Research, Inc.
  9. Jeffrey C. Fuhrer, 2000. "Habit Formation in Consumption and Its Implications for Monetary-Policy Models," American Economic Review, American Economic Association, vol. 90(3), pages 367-390, June.
  10. Douglas Staiger & James H. Stock, 1997. "Instrumental Variables Regression with Weak Instruments," Econometrica, Econometric Society, vol. 65(3), pages 557-586, May.
  11. Laurent E. Calvet & John Y. Campbell & Paolo Sodini, 2009. "Fight Or Flight? Portfolio Rebalancing by Individual Investors-super-," The Quarterly Journal of Economics, MIT Press, vol. 124(1), pages 301-348, February.
  12. Constantinides, George M, 1990. "Habit Formation: A Resolution of the Equity Premium Puzzle," Journal of Political Economy, University of Chicago Press, vol. 98(3), pages 519-43, June.
  13. Uribe, Martin, 2002. "The price-consumption puzzle of currency pegs," Journal of Monetary Economics, Elsevier, vol. 49(3), pages 533-569, April.
  14. Samuelson, Paul A, 1969. "Lifetime Portfolio Selection by Dynamic Stochastic Programming," The Review of Economics and Statistics, MIT Press, vol. 51(3), pages 239-46, August.
  15. Jermann, Urban J., 1998. "Asset pricing in production economies," Journal of Monetary Economics, Elsevier, vol. 41(2), pages 257-275, April.
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