Stock Market Mean Reversion and Portfolio Choice over the Life Cycle

101 Pages Posted: 18 Aug 2015 Last revised: 9 Sep 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

Multiple version iconThere are 2 versions of this paper

Date Written: September 3, 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). 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

Michaelides, Alexander and Zhang, Yuxin, Stock Market Mean Reversion and Portfolio Choice over the Life Cycle (September 3, 2015). Netspar Discussion Paper No. 06/2015-018. Available at SSRN: https://ssrn.com/abstract=2645546 or http://dx.doi.org/10.2139/ssrn.2645546

Alexander Michaelides (Contact Author)

Imperial College Business School ( email )

South Kensington Campus
Exhibition Road
London SW7 2AZ, SW7 2AZ
United Kingdom

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Yuxin Zhang

Renmin University of China ( email )

Renmin University of China
Haidian District
Beijing, Beijing 100872
China

HOME PAGE: http://https://sites.google.com/view/yuxin-zhang/home

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