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Wealth Shocks and Risk Aversion

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Modern literature departs from time-separable constant relative risk aversion preferences to explain asset pricing facts. This deviation typically implies that wealth shocks generate transitory variations in agents’ relative risk aversion and, possibly, portfolio re-allocations over time. I empirically analyze this relationship using U.S. macroeconomic data and and evidence for time-variation in portfolio shares that is consistent with counter-cyclical risk aversion. These results suggest, therefore, that wealth-dependent, habit-formation or loss and disappointment aversion utility functions are a good description of preferences. Controlling for observed versus expected asset returns, I also show that: (i) wealth effects are significant (although temporary) and there is no evidence of inertia contrary to Brunnermeier and Nagel (2006); and (ii) the consumption-wealth ratio (Lettau and Ludvigson, 2001), the labor income risk (Julliard, 2004) and the labor income-consumption ratio (Santos and Veronesi, 2006) partially explain changes in the risky asset share.

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Paper provided by NIPE - Universidade do Minho in its series NIPE Working Papers with number 28/2007.

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Date of creation: 2007
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Handle: RePEc:nip:nipewp:28/2007

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Keywords: wealth; risk aversion.;

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Cited by:
  1. Adam Eric Greenberg, 2013. "When imagining future wealth influences risky decision making," Judgment and Decision Making, Society for Judgment and Decision Making, vol. 8(3), pages 268-277, May.
  2. Ricardo M. Sousa, 2009. "Wealth Effetcs on Consumption: Evidence from the euro area," NIPE Working Papers 12/2009, NIPE - Universidade do Minho.

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