Wealth Effect on Portfolio Allocation in Incomplete Markets
71 Pages Posted: 22 Apr 2020 Last revised: 30 Aug 2021
Date Written: April 20, 2020
We develop a novel five-component decomposition of optimal dynamic portfolio choice, which reveals the simultaneous impacts from market incompleteness and wealth-dependent utilities. Under the HARA utility and a nonrandom interest rate, we can explicitly solve for the optimal policy as a combination of a bond holding scheme and the corresponding simpler CRRA strategy. Under a stochastic volatility model estimated on US equity data, we use closed-form solution to demonstrate the sophisticated impacts from the wealth-dependent utilities, including cycle-dependence and hysteresis effect in optimal portfolio allocation, as well as a risk-return trade-off in investment performance.
Keywords: optimal portfolio choice, stochastic volatility, incomplete market, wealth-dependent utility, closed-form
JEL Classification: C61, C63, G11
Suggested Citation: Suggested Citation