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

54 Pages Posted: 5 Jun 2003

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: April 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 labour 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 behaviour, 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 labour 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 Labour Income Risk (April 2003). CEPR Discussion Paper No. 3868. Available at SSRN: https://ssrn.com/abstract=413402

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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