Stock Market Mean Reversion and Portfolio Choice over the Life Cycle

46 Pages Posted: 14 Feb 2015 Last revised: 18 Nov 2015

See all articles by Alexander Michaelides

Alexander Michaelides

Imperial College Business School; Centre for Economic Policy Research (CEPR)

Yuxin Zhang

Renmin University of China; Renmin University of China

Multiple version iconThere are 2 versions of this paper

Date Written: November 6, 2015

Abstract

We solve for optimal consumption and portfolio choice in a life-cycle model with short-sales and borrowing constraints, undiversifiable labor income risk and a predictable, time-varying, equity premium and show that the investor pursues aggressive market timing strategies. Importantly, in the presence of stock market predictability, the model suggests that the conventional financial advice of reducing stock market exposure as retirement approaches is correct on average, but ignoring changing market information can lead to substantial welfare losses. Therefore, enhanced target-date funds (ETDFs) that condition on expected equity premia increase welfare relative to target-date funds (TDFs).

Keywords: Portfolio Choice over the Life Cycle, Stock Market Mean Reversion, Stock Market Predictability, Hedging Demands, Lifestyle funds, enhanced target-date funds

JEL Classification: E21, G11

Suggested Citation

Michaelides, Alexander and Zhang, Yuxin and Zhang, Yuxin, Stock Market Mean Reversion and Portfolio Choice over the Life Cycle (November 6, 2015). Journal of Financial and Quantitative Analysis (JFQA), Forthcoming, Available at SSRN: https://ssrn.com/abstract=2564447 or http://dx.doi.org/10.2139/ssrn.2564447

Alexander Michaelides (Contact Author)

Imperial College Business School ( email )

South Kensington Campus
Exhibition Road
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United Kingdom

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Yuxin Zhang

Renmin University of China ( email )

Room B906
Xianjin Building
Beijing, Beijing 100872
China

Renmin University of China ( email )

57 Zhong Guanchun Road
Haidian District
Beijing, Beijing 100872
China

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