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Precautionary saving and portfolio allocation: DP by GMM

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  • Letendre, Marc-Andre
  • Smith, Gregor W.

Abstract

There is much research on consumption-savings problems with risky labor incomeand a constant interest rate and also on portfolio allocation with risky returns but nonstochastic labor income. Less is known quantitatively about the interaction between the two forms of risk. Under CRRA utility, undiversifiable income risk should be reflected in both savings rates and portfolio allocations. To quantify these effects in a model of consumptionand portfolio choice, we adopt a semi-parametric projection method for solving dynamic programmes, based on generalized method of moments estimation of the parametersof approximate decision rules. We find that background income risk does affect optimal portfolios but that this effect may be difficult to detect empirically.
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Suggested Citation

  • Letendre, Marc-Andre & Smith, Gregor W., 2001. "Precautionary saving and portfolio allocation: DP by GMM," Journal of Monetary Economics, Elsevier, vol. 48(1), pages 197-215, August.
  • Handle: RePEc:eee:moneco:v:48:y:2001:i:1:p:197-215
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    1. Roberto Bande & Dolores Riveiro, 2013. "Private Saving Rates and Macroeconomic Uncertainty: Evidence from Spanish Regional Data," The Economic and Social Review, Economic and Social Studies, vol. 44(3), pages 323-349.
    2. Luc Arrondel & Hector Calvo Pardo & Xisco Oliver, 2007. "Temperant portfolio choice and background risk: evidence from France," Working Papers halshs-00588069, HAL.
    3. Smith, Gregor W. & Zin, Stanley E., 1997. "Real business-cycle realizations," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 47(1), pages 243-280, December.
    4. Letendre, Marc-Andre, 2004. "Semi-parametric predictions of the intertemporal approach to the current account," Journal of International Economics, Elsevier, vol. 64(2), pages 363-386, December.
    5. Sule Alan, 2004. "Precautionary Wealth and Portfolio Allocation: Evidence from Canadian Microdata," Social and Economic Dimensions of an Aging Population Research Papers 117, McMaster University.
    6. Luis M. Viceira, 2001. "Optimal Portfolio Choice for Long‐Horizon Investors with Nontradable Labor Income," Journal of Finance, American Finance Association, vol. 56(2), pages 433-470, April.
    7. Feigenbaum, James, 2005. "Second-, third-, and higher-order consumption functions: a precautionary tale," Journal of Economic Dynamics and Control, Elsevier, vol. 29(8), pages 1385-1425, August.
    8. Veld-Merkoulova, Yulia V., 2011. "Investment horizon and portfolio choice of private investors," International Review of Financial Analysis, Elsevier, vol. 20(2), pages 68-75, April.
    9. Wilson, Bonnie, 2003. "Diversification of risk and saving," The Quarterly Review of Economics and Finance, Elsevier, vol. 43(4), pages 697-712.
    10. Jaime Ruiz-Tagle, 2006. "Financial Markets Incompleteness and Inequality Over the Life-Cycle," Working Papers Central Bank of Chile 405, Central Bank of Chile.

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    JEL classification:

    • D91 - Microeconomics - - Micro-Based Behavioral Economics - - - Role and Effects of Psychological, Emotional, Social, and Cognitive Factors on Decision Making
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • C63 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Computational Techniques

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