Optimal Life-Cycle Asset Allocation: Understanding the Empirical Evidence

Abstract

We show that a life-cycle model with realistically calibrated uninsurable labor income risk and moderate risk aversion can simultaneously match stock market participation rates and asset allocation decisions conditional on participation. The key ingredients of the model are Epstein-Zin preferences, two risky assets (stocks and long-term bonds), and a fixed entry cost associated with the investment in risky assets. In this context, moderate preference heterogeneity in risk aversion and in the elasticity of intertemporal substitution is sufficient to deliver our results. Moreover, the model rationalizes the asset allocation puzzle of Canner, Mankiw and Weil (1997).

Keywords: Life-Cycle Models, Portfolio Choice, Preference Heterogeneity, Liquidity Constraints, Stock Market Participation, Uninsurable Labor Income Risk

JEL Classification: G11