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Robust consumption and portfolio choices with habit formation

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  • Li, Tongtong
  • Wang, Shibo
  • Yang, Jinqiang

Abstract

This paper explores the effect of homothetic model uncertainty on an agent's optimal consumption and portfolio choices with multiplicative habit formation. We solve the max-min expected utility problem to obtain the optimal consumption and portfolio rules. Detection error probabilities, which were calculated using Monte Carlo simulations, calibrate reasonable ambiguity aversion parameters. Results indicate that ambiguity leads to a more aggressive consumption strategy but more conservative investment choices and that the opposite effect is observed on the optimal decision between model uncertainty and habit formation. Notably, we find that the dynamics of investment are a mean-reverting process and that model uncertainty can increase this reversion rate. Furthermore, we discover a distinction between ambiguity and risk. The practical significance of this article is that it provides an alternative theoretical explanation for the excess sensitivity and smoothness puzzles of consumption from the perspective of ambiguity.

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  • Li, Tongtong & Wang, Shibo & Yang, Jinqiang, 2021. "Robust consumption and portfolio choices with habit formation," Economic Modelling, Elsevier, vol. 98(C), pages 227-246.
  • Handle: RePEc:eee:ecmode:v:98:y:2021:i:c:p:227-246
    DOI: 10.1016/j.econmod.2021.03.001
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    Cited by:

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    3. Luo, Deqing & Shan, Xun & Yan, Jingzhou & Yan, Qianhui, 2023. "Sustainable investment under ESG volatility and ambiguity," Economic Modelling, Elsevier, vol. 128(C).
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    6. Daniel Bartl & Ariel Neufeld & Kyunghyun Park, 2023. "Sensitivity of robust optimization problems under drift and volatility uncertainty," Papers 2311.11248, arXiv.org.
    7. Shen, Zhuyi & Wang, Shibo & Yang, Jinqiang, 2023. "Robust adoption and valuation in tokenomics," Economic Modelling, Elsevier, vol. 129(C).

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    More about this item

    Keywords

    Homothetic model uncertainty; Multiplicative habit formation; Detection error probabilities; Excess sensitivity; Excess smoothness;
    All these keywords.

    JEL classification:

    • C61 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Optimization Techniques; Programming Models; Dynamic Analysis
    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions

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