IDEAS home Printed from https://ideas.repec.org/
MyIDEAS: Log in (now much improved!) to save this paper

Rational Inattention, Portfolio Choice, and the Equity Premium

  • Yulei Luo

    ()

    (School of Economics and Finance, University of Hong Kong)

This paper explores how the introduction of Rational Inattention (RI) affects optimal consumption and portfolio rules and asset pricing in the consumption-based CAPM framework. I first solve an otherwise standard portfolio choice and asset pricing model with RI explicitly and show that RI can generate smooth consumption process and low contemporaneous correlation between consumption growth and asset returns. Second, it is shown that in the RI economy asset returns are determined by the ultimate consumption risk rather than the contemporaneous risk. As a result, RI has a potential to reduce the demand for the risky asset and could endo- genize limited stock market participation hypothesis. Third, I show that RI can disentangle the coefficient of relative risk aversion with the elasticity of intertemporal substitution endoge- neously by increasing the effective CRRA. RI can therefore be an alternative explanation for the equity premium puzzle and the risk free rate puzzle. Fourth, I compare RI with recursive preference, robustness, and habit formation. Fifth, I investigate the implications of RI for optimal consumption and portfolio choice when investment opportunities are stochastic and labor income is modelled explicitly. Finally, I propose a general equilibrium asset pricing framework to examine the implications of RI for the equity premium, the mean ratio of price to dividend, and the equity volatility in equilibrium.

If you experience problems downloading a file, check if you have the proper application to view it first. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.

File URL: http://www.princeton.edu/~yluo/yluoJMP05.pdf
File Function: main text
Download Restriction: no

File URL: http://repec.org/sce2006/up.30414.1138667261.pdf
Download Restriction: no

Paper provided by Society for Computational Economics in its series Computing in Economics and Finance 2006 with number 56.

as
in new window

Length:
Date of creation: 04 Jul 2006
Date of revision:
Handle: RePEc:sce:scecfa:56
Contact details of provider: Web page: http://comp-econ.org/
Email:


More information through EDIRC

References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:

as in new window
  1. Lawrence J. Christiano & Michele Boldrin & Jonas D. M. Fisher, 2001. "Habit Persistence, Asset Returns, and the Business Cycle," American Economic Review, American Economic Association, vol. 91(1), pages 149-166, March.
  2. John Y. Campbell & John H. Cochrane, 1994. "By force of habit: a consumption-based explanation of aggregate stock market behavior," Working Papers 94-17, Federal Reserve Bank of Philadelphia.
  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. Gali, Jordi, 1994. "Keeping Up with the Joneses: Consumption Externalities, Portfolio Choice, and Asset Prices," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 26(1), pages 1-8, February.
  5. Jonathan A. Parker & Christian Julliard, 2004. "Consumption Risk and the Cross-Section of Expected Returns," Working Papers 138, Princeton University, Woodrow Wilson School of Public and International Affairs, Discussion Papers in Economics.
  6. Xavier Gabaix & David Laibson, 2002. "The 6D Bias and the Equity Premium Puzzle," Harvard Institute of Economic Research Working Papers 1947, Harvard - Institute of Economic Research.
  7. John H. Cochrane & Lars Peter Hansen, 1992. "Asset Pricing Explorations for Macroeconomics," NBER Working Papers 4088, National Bureau of Economic Research, Inc.
  8. Lars Peter Hansen & Ravi Jagannathan, 1990. "Implications of security market data for models of dynamic economies," Discussion Paper / Institute for Empirical Macroeconomics 29, Federal Reserve Bank of Minneapolis.
  9. Campbell, John Y., 1999. "Asset prices, consumption, and the business cycle," Handbook of Macroeconomics, in: J. B. Taylor & M. Woodford (ed.), Handbook of Macroeconomics, edition 1, volume 1, chapter 19, pages 1231-1303 Elsevier.
  10. Jordi Mondria & Climent Quintana Domeque, 2012. "Financial contagion and attention allocation," Working Papers. Serie AD 2012-07, Instituto Valenciano de Investigaciones Económicas, S.A. (Ivie).
  11. 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, 04.
  12. Lynch, Anthony W, 1996. " Decision Frequency and Synchronization across Agents: Implications for Aggregate Consumption and Equity Return," Journal of Finance, American Finance Association, vol. 51(4), pages 1479-97, September.
  13. Campbell, John, 1993. "Intertemporal Asset Pricing Without Consumption Data," Scholarly Articles 3221491, Harvard University Department of Economics.
  14. repec:pri:wwseco:dp223 is not listed on IDEAS
  15. Karen E. Dynan & Dean M. Maki, 2001. "Does stock market wealth matter for consumption?," Finance and Economics Discussion Series 2001-23, Board of Governors of the Federal Reserve System (U.S.).
  16. John Y. Campbell, 2002. "Consumption-Based Asset Pricing," Harvard Institute of Economic Research Working Papers 1974, Harvard - Institute of Economic Research.
  17. Kenneth Kasa, 2006. "Robustness and Information Processing," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 9(1), pages 1-33, January.
  18. Philippe Weil, 1989. "The Equity Premium Puzzle and the Riskfree Rate Puzzle," NBER Working Papers 2829, National Bureau of Economic Research, Inc.
  19. John Cochrane, 2005. "Financial Markets and the Real Economy," NBER Working Papers 11193, National Bureau of Economic Research, Inc.
  20. Campbell, John Y. & Viceira, Luis M., 2002. "Strategic Asset Allocation: Portfolio Choice for Long-Term Investors," OUP Catalogue, Oxford University Press, number 9780198296942, December.
  21. repec:pri:wwseco:dp229 is not listed on IDEAS
  22. Yulei Luo, 2005. "Consumption Dynamics under Information Processing Constraints," Macroeconomics 0505011, EconWPA, revised 03 Jun 2005.
  23. Gennotte, Gerard, 1986. " Optimal Portfolio Choice under Incomplete Information," Journal of Finance, American Finance Association, vol. 41(3), pages 733-46, July.
  24. Alberto Giovannini & Philippe Weil, 1989. "Risk Aversion and Intertemporal Substitution in the Capital Asset Pricing Model," NBER Working Papers 2824, National Bureau of Economic Research, Inc.
  25. Jonathan A. Parker, 2003. "Consumption Risk and Expected Stock Returns," American Economic Review, American Economic Association, vol. 93(2), pages 376-382, May.
  26. Annette Vissing-Jorgensen, 2002. "Limited Asset Market Participation and the Elasticity of Intertemporal Substitution," NBER Working Papers 8896, National Bureau of Economic Research, Inc.
  27. Reis, Ricardo, 2006. "Inattentive consumers," Journal of Monetary Economics, Elsevier, vol. 53(8), pages 1761-1800, November.
  28. Ravi Bansal & Amir Yaron, 2000. "Risks for the Long Run: A Potential Resolution of Asset Pricing Puzzles," NBER Working Papers 8059, National Bureau of Economic Research, Inc.
  29. Lin Peng & Wei Xiong, 2005. "Investor Attention: Overconfidence and Category Learning," NBER Working Papers 11400, National Bureau of Economic Research, Inc.
  30. Lixin Huang & Hong Liu, 2007. "Rational Inattention and Portfolio Selection," Journal of Finance, American Finance Association, vol. 62(4), pages 1999-2040, 08.
  31. Robert E. Hall, 1981. "Intertemporal Substitution in Consumption," NBER Working Papers 0720, National Bureau of Economic Research, Inc.
  32. Kocherlakota, N., 1995. "The Equity Premium: It's Still a Puzzle," Working Papers 95-05, University of Iowa, Department of Economics.
  33. Annette Vissing-Jorgensen, 2002. "Limited Asset Market Participation and the Elasticity of Intertemporal Substitution," Journal of Political Economy, University of Chicago Press, vol. 110(4), pages 825-853, August.
  34. Pascal J. Maenhout, 2004. "Robust Portfolio Rules and Asset Pricing," Review of Financial Studies, Society for Financial Studies, vol. 17(4), pages 951-983.
  35. Laura Veldkamp & Stijn Van Nieuwerburgh, 2005. "Information Acquisition and Portfolio Underdiversification," 2005 Meeting Papers 77, Society for Economic Dynamics.
  36. Sims, Christopher A., 2003. "Implications of rational inattention," Journal of Monetary Economics, Elsevier, vol. 50(3), pages 665-690, April.
  37. Luo Yulei & Young Eric R, 2009. "Rational Inattention and Aggregate Fluctuations," The B.E. Journal of Macroeconomics, De Gruyter, vol. 9(1), pages 1-43, April.
  38. Sims, Christopher A., 2005. "Rational inattention: a research agenda," Discussion Paper Series 1: Economic Studies 2005,34, Deutsche Bundesbank, Research Centre.
  39. Mehra, Rajnish & Prescott, Edward C., 1985. "The equity premium: A puzzle," Journal of Monetary Economics, Elsevier, vol. 15(2), pages 145-161, March.
  40. repec:fth:harver:1421 is not listed on IDEAS
  41. Martha Starr-McCluer, 1998. "Stock market wealth and consumer spending," Finance and Economics Discussion Series 1998-20, Board of Governors of the Federal Reserve System (U.S.).
  42. 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.
  43. Epstein, Larry G & Zin, Stanley E, 1989. "Substitution, Risk Aversion, and the Temporal Behavior of Consumption and Asset Returns: A Theoretical Framework," Econometrica, Econometric Society, vol. 57(4), pages 937-69, July.
  44. Thaler, Richard H, 1990. "Saving, Fungibility, and Mental Accounts," Journal of Economic Perspectives, American Economic Association, vol. 4(1), pages 193-205, Winter.
  45. Jonathan A. Parker, 2001. "The Consumption Risk of the Stock Market," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 32(2), pages 279-348.
  46. Hansen, Lars Peter & Singleton, Kenneth J, 1983. "Stochastic Consumption, Risk Aversion, and the Temporal Behavior of Asset Returns," Journal of Political Economy, University of Chicago Press, vol. 91(2), pages 249-65, April.
Full references (including those not matched with items on IDEAS)

This item is not listed on Wikipedia, on a reading list or among the top items on IDEAS.

When requesting a correction, please mention this item's handle: RePEc:sce:scecfa:56. See general information about how to correct material in RePEc.

For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Christopher F. Baum)

If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

If references are entirely missing, you can add them using this form.

If the full references list an item that is present in RePEc, but the system did not link to it, you can help with this form.

If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your profile, as there may be some citations waiting for confirmation.

Please note that corrections may take a couple of weeks to filter through the various RePEc services.

This information is provided to you by IDEAS at the Research Division of the Federal Reserve Bank of St. Louis using RePEc data.