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Portfolio Choice With Internal Habit Formation: A Life-Cycle Model With Uninsurable Labor Income Risk

Author

Listed:
  • Francisco Gomes

    (London Business School)

  • Alexander Michaelides

    (London School of Economics)

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 labor 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 behavior, the internal habit formation model is dominated by its time-separable utility counterpart. (Copyright: Elsevier)

Suggested Citation

  • Francisco Gomes & Alexander Michaelides, 2003. "Portfolio Choice With Internal Habit Formation: A Life-Cycle Model With Uninsurable Labor Income Risk," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 6(4), pages 729-766, October.
    • Handle: RePEc:red:issued:v:6:y:2003:i:4:p:729-766
    DOI: 10.1016/S1094-2025(03)00059-0
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    More about this item

    Keywords

    Life-cycle asset allocation; Habit formation; Liquidity constraints; Stock market participation costs; Uninsurable labor income risk;
    All these keywords.

    JEL classification:

    • E21 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Consumption; Saving; Wealth
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions

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