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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. Sousa, Ricardo M., 2009. "Wealth effects on consumption: evidence from the euro area," Working Paper Series 1050, European Central Bank.
  2. 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.

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