Life-Cycle Consumption and Portfolio Choice with an Imperfect Predictor

Abstract

I study the effect of observable predictors that imperfectly predict conditional expected stock returns on optimal life-cycle consumption and portfolio choice in the presence of undiversifiable labor income risk. Investors filter the unobservable expected stock returns from realized predictive variables and stock returns. Young stockholders hold more conservative portfolios, better matching empirical observations, than models assuming a predictor perfectly delivering the conditional expected stock return or models assuming i.i.d. stock returns. Welfare losses from ignoring imperfect predictability can be substantial.

Keywords: Portfolio Choice over the Life Cycle, Stock Market Mean Reversion, Filtering, Stock Market Predictability, Imperfect Predictor

JEL Classification: D14, G11, G17