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Long-run Consumption Risk and Asset Allocation under Recursive Utility and Rational Inattention

  • Luo, Yulei
  • Young, Eric

We study the portfolio decision of a household with limited information-processing capacity (rational inattention or RI) in a setting with recursive utility. We find that rational inattention combined with a preference for early resolution of uncertainty could lead to a significant drop in the share of portfolios held in risky assets, even when the departure from standard expected utility with rational expectations is small. In addition, we show that the equilibrium equity premium increases with the degree of inattention because inattentive investors with recursive utility face greater long-run risk and thus require higher compensation in equilibrium. Our results are robust to the presence of correlation between the equity return and the RI-induced noise and the presence of non-tradable labor income.

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File URL: http://mpra.ub.uni-muenchen.de/57112/1/MPRA_paper_52904.pdf
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Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 52904.

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Date of creation: 08 Jul 2013
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Handle: RePEc:pra:mprapa:52904
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  1. Mondria, Jordi, 2010. "Portfolio choice, attention allocation, and price comovement," Journal of Economic Theory, Elsevier, vol. 145(5), pages 1837-1864, September.
  2. Stephen G. Cecchetti & Pok-sang Lam & Nelson C. Mark, 1998. "Asset Pricing with Distorted Beliefs: Are Equity Returns Too Good To Be True?," NBER Working Papers 6354, National Bureau of Economic Research, Inc.
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  9. Mirko Wiederholt & Bartosz Mackowiak, 2005. "Optimal Sticky Prices under Rational Inattention," 2005 Meeting Papers 369, Society for Economic Dynamics.
  10. Yulei Luo & Eric R. Young, 2010. "Risk-Sensitive Consumption and Savings under Rational Inattention," American Economic Journal: Macroeconomics, American Economic Association, vol. 2(4), pages 281-325, October.
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  13. Stavros Panageas & Janice C. Eberly & Andrew B. Abel, 2011. "Optimal Inattention to the Stock Market with Information Costs and Transactions Costs," 2011 Meeting Papers 102, Society for Economic Dynamics.
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  30. repec:fth:harver:1421 is not listed on IDEAS
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