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Optimal Life‐Cycle Asset Allocation: Understanding the Empirical Evidence

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  • FRANCISCO GOMES
  • ALEXANDER MICHAELIDES

Abstract

We show that a life‐cycle model with realistically calibrated uninsurable labor income risk and moderate risk aversion can simultaneously match stock market participation rates and asset allocation decisions conditional on participation. The key ingredients of the model are Epstein–Zin preferences, a fixed stock market entry cost, and moderate heterogeneity in risk aversion. Households with low risk aversion smooth earnings shocks with a small buffer stock of assets, and consequently most of them (optimally) never invest in equities. Therefore, the marginal stockholders are (endogenously) more risk averse, and as a result they do not invest their portfolios fully in stocks.

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  • Francisco Gomes & Alexander Michaelides, 2005. "Optimal Life‐Cycle Asset Allocation: Understanding the Empirical Evidence," Journal of Finance, American Finance Association, vol. 60(2), pages 869-904, April.
    • Handle: RePEc:bla:jfinan:v:60:y:2005:i:2:p:869-904
    DOI: 10.1111/j.1540-6261.2005.00749.x
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    JEL classification:

    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions

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