Stock Market Mean Reversion and Portfolio Choice over the Life Cycle
101 Pages Posted: 18 Aug 2015 Last revised: 9 Sep 2015
Date Written: September 3, 2015
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). Out-of-sample analysis supports these conclusions.
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: Suggested Citation