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Portfolio choice with internal habit formation: a life-cycle model with uninsurable labour income risk

Gomes, Francisco and Michaelides, Alexander (2003) Portfolio choice with internal habit formation: a life-cycle model with uninsurable labour income risk. 3868. Centre for Economic Policy Research, London, UK.

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Abstract

Motivated by the success of internal habit formation preferences in explaining asset-pricing puzzles, we introduce these preferences in a life-cycle model of consumption and portfolio choice with liquidity constraints, undiversifiable labour income risk and stock-market participation costs. In contrast to the initial motivation, we find that the model is not able to simultaneously match two very important stylized facts: a low stock market participation rate, and moderate equity holdings for those households that do invest in stocks. Habit formation increases wealth accumulation because the intertemporal consumption-smoothing motive is stronger. As a result, households start participating in the stock market very early in life, and invest their portfolios almost fully in stocks. Therefore, we conclude that, with respect to its ability to match the empirical evidence on asset allocation behaviour, the internal habit formation model is dominated by its time-separable utility counterpart.

Item Type: Monograph (Discussion Paper)
Official URL: http://www.cepr.org
Additional Information: © 2003 Francisco J Gomes and Alex Michaelides
Library of Congress subject classification: H Social Sciences > HG Finance
Journal of Economic Literature Classification System: G - Financial Economics > G1 - General Financial Markets > G11 - Portfolio Choice; Investment Decisions
E - Macroeconomics and Monetary Economics > E2 - Consumption, Saving, Production, Employment, and Investment > E21 - Macroeconomics: Consumption; Saving; Aggregate Physical and Financial Consumer Wealth
Sets: Research centres and groups > Financial Markets Group (FMG)
Collections > Economists Online
Departments > Economics
Collections > LSE Financial Markets Group (FMG) Working Papers
Rights: http://www.lse.ac.uk/library/usingTheLibrary/academicSupport/OA/depositYourResearch.aspx
Identification Number: 3868
Date Deposited: 04 Jun 2008 16:32
URL: http://eprints.lse.ac.uk/5363/

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