Wealth Shocks and Risk Aversion

University of Minho, NIPE Working Paper No. 28/2007

48 Pages Posted: 19 Nov 2007 Last revised: 29 Jan 2009

See all articles by Ricardo M. Sousa

Ricardo M. Sousa

University of Minho; Economic Policies Research Unit (NIPE); London School of Economics & Political Science (LSE) - Financial Markets Group; London School of Economics

Date Written: October 30, 2007

Abstract

Modern literature departs from time-separable constant relative risk aversion preferences to explain asset pricing facts. This deviation typically implies that wealth shocks generate transitory variations in agents' relative risk aversion and, possibly, portfolio re-allocations over time.

I empirically analyze this relationship using U.S. macroeconomic data and find evidence for time-variation in portfolio shares that is consistent with counter-cyclical risk aversion. These results suggest, therefore, that wealth-dependent, habit-formation or loss and disappointment aversion utility functions are a good description of preferences.

Controlling for observed versus expected asset returns, I also show that: (i) wealth effects are significant (although temporary) and there is no evidence of inertia contrary to Brunnermeier and Nagel (2006); and (ii) the consumption-wealth ratio (Lettau and Ludvigson, 2001), the labor income risk (Julliard, 2004) and the labor income-consumption ratio (Santos and Veronesi, 2006) partially explain changes in the risky asset share.

Keywords: Wealth, risk aversion

JEL Classification: E21, G11, E44

Suggested Citation

Sousa, Ricardo Magalhaes, Wealth Shocks and Risk Aversion (October 30, 2007). University of Minho, NIPE Working Paper No. 28/2007, Available at SSRN: https://ssrn.com/abstract=1030850 or http://dx.doi.org/10.2139/ssrn.1030850

Ricardo Magalhaes Sousa (Contact Author)

University of Minho ( email )

Campus Gualtar
Braga, 4710-057
Portugal
+351253604584 (Phone)
+351253676375 (Fax)

HOME PAGE: http://www.eeg.uminho.pt/economia/rjsousa

Economic Policies Research Unit (NIPE) ( email )

Campus de Gualtar
Braga, 4710-057
Portugal
+351253604584 (Phone)
+351253676375 (Fax)

HOME PAGE: http://www.eeg.uminho.pt/economia/rjsousa

London School of Economics & Political Science (LSE) - Financial Markets Group ( email )

Houghton Street
London WC2A 2AE
United Kingdom

London School of Economics ( email )

Houghton Street
London, WC2A 2AE
United Kingdom

HOME PAGE: http://econ.lse.ac.uk

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