Portfolio Choice with Internal Habit Formation: A Life-Cycle Model with Uninsurable Labor Income Risk

52 Pages Posted: 1 Feb 2002

See all articles by Francisco Gomes

Francisco Gomes

London Business School

Alexander Michaelides

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

Date Written: March 2003

Abstract

Motivated by the success of internal habit formation preferences in explaining asset pricing puzzles, we introduce these preferences in a life-cycle model of consumption and portfolio choice with liquidity constraints, undiversifiable labor income risk and stock-market participation costs. In contrast to the initial motivation, we find that the model is not able to simultaneously match two very important stylized facts: A low stock market participation rate, and moderate equity holdings for those households that do invest in stocks. Habit formation increases wealth accumulation because the intertemporal consumption smoothing motive is stronger. As a result, households start participating in the stock market very early in life, and invest their portfolios almost fully in stocks. Therefore, we conclude that, with respect to its ability to match the empirical evidence on asset allocation behavior, the internal habit formation model is dominated by its time-separable utility counterpart.

Keywords: Life-Cycle Asset Allocation, Habit Formation, Liquidity Constraints, Stock Market Participation Costs, Uninsurable Labor Income Risk

JEL Classification: E21, G11

Suggested Citation

Gomes, Francisco and Michaelides, Alexander, Portfolio Choice with Internal Habit Formation: A Life-Cycle Model with Uninsurable Labor Income Risk (March 2003). Available at SSRN: https://ssrn.com/abstract=298459 or http://dx.doi.org/10.2139/ssrn.298459

Francisco Gomes (Contact Author)

London Business School ( email )

Institute of Finance and Accounting
Sussex Place - Regent's Park
London NW1 4SA
United Kingdom
+44 20 7262 5050 (Phone)
+44 20 7724 3317 (Fax)

HOME PAGE: http://www.london.edu/faculty/fgomes

Alexander Michaelides

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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