Life-Cycle Asset Allocation: A Model with Borrowing Constraints, Uninsurable Labor Income Risk and Stock-Market Participation Costs

46 Pages Posted: 8 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: June 2002

Abstract

We study life-cycle asset allocation in the presence of liquidity constraints and undiversifiable labor income risk. The model includes three different assets (cash, long-term government bonds and stocks) and it takes into account the life-cycle profile of housing expenditures. With a modest correlation between stock returns and earnings innovations, the mean share of wealth invested in stocks never exceeds 45% during working-life. Moreover, the combination of uninsurable human capital and borrowing constraints rationalizes the asset allocation puzzle of Canner, Mankiw and Weil (1997). Nevertheless we argue that asset allocation models must match another important feature of the data: a low stock market participation rate. Along this dimension the model provides a very modest improvement, still predicting a counterfactually high participation rate. We show that this arises from the link between risk aversion and prudence, implying that explanations for the participation puzzle based on the role of background risk are unlikely to succeed.

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

JEL Classification: G11

Suggested Citation

Gomes, Francisco and Michaelides, Alexander, Life-Cycle Asset Allocation: A Model with Borrowing Constraints, Uninsurable Labor Income Risk and Stock-Market Participation Costs (June 2002). Available at SSRN: https://ssrn.com/abstract=299388 or http://dx.doi.org/10.2139/ssrn.299388

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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