Portfolio Choice, Liquidity Constraints and Stock Market Mean Reversion

50 Pages Posted: 12 Jun 2001

See all articles by Alexander Michaelides

Alexander Michaelides

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

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Date Written: June 2001

Abstract

This Paper solves numerically for the optimal consumption and portfolio choice of an infinitely lived investor facing short sales and borrowing constraints, undiversifiable labour income risk and a predictable time varying equity premium. The investor aggressively times the market while positive correlation between permanent earnings shocks and stock return innovations generates a substantial hedging demand for the riskless asset. Moreover, a speculative increase in savings arises when stock returns are expected to be high and conversely when future returns are expected to be low. Small information/optimization costs can make it optimal for an investor to assume i.i.d excess stock returns, both because liquidity constraints can be frequently binding and because households can smooth idiosyncratic earnings shock using a small buffer stock of wealth.

Keywords: Buffer stock saving, liquidity constraints, portfolio choice, stock market mean reversion, stock market predictability

JEL Classification: E21, G11

Suggested Citation

Michaelides, Alexander, Portfolio Choice, Liquidity Constraints and Stock Market Mean Reversion (June 2001). CEPR Discussion Paper No. 2823. Available at SSRN: https://ssrn.com/abstract=273275

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

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