Abstract

http://ssrn.com/abstract=1094988
 
 

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Discrete-Time Optimization of Consumption and Investment Decisions Given Intolerance for a Decline in Standard of Living


Amit V. Bhandari


IEMS, Northwestern University

John R. Birge


University of Chicago - Booth School of Business

2/18/08


Abstract:     
We extend Samuelson's (1969) discrete-time dynamic consumption and investment optimization problem to the case where the investor is intolerant of any decline in her standard of living. This constraint represents a strong form of habit formation such that the consumption rate is non-decreasing over time. To achieve this objective, the investor first guarantees a consumption perpetuity at the current consumption rate and then allocates the remaining wealth under a state-dependent, adjusted coefficient of relative risk aversion. We study the impact of the length of the time interval on the optimal consumption and investment policies. This effect has implications for investors considering investments in assets, such as hedge funds and private equity, that have restrictions on trading intervals.

Number of Pages in PDF File: 41

Keywords: consumption-portfolio choice, habit formation, alternative investments, hedge funds, stochastic dynamic programming

JEL Classification: C61, E21, G11, G23, H30

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Date posted: February 19, 2008  

Suggested Citation

Bhandari, Amit V. and Birge, John R., Discrete-Time Optimization of Consumption and Investment Decisions Given Intolerance for a Decline in Standard of Living (2/18/08). Available at SSRN: http://ssrn.com/abstract=1094988 or http://dx.doi.org/10.2139/ssrn.1094988

Contact Information

Amit V. Bhandari (Contact Author)
IEMS, Northwestern University ( email )
Evanston, IL 60208-3119
United States
John R. Birge
University of Chicago - Booth School of Business ( email )
5807 S. Woodlawn Avenue
Chicago, IL 60637
United States

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