The Role of Risk Aversion and Intertemporal Substitution in Dynamic Consumption-Portfolio Choice with Recursive Utility

Abstract

The objective of this note is to understand the implications for consumption and portfolio choice of the separation of an investor's risk aversion and elasticity of intertemporal substitution that is made possible by recursive utility, in contrast to expected utility where the two are dictated by the same parameter. In particular, we study whether the optimal consumption and portfolio decisions depend on risk aversion, elasticity of intertemporal substitution, or both. We find that, in general, the consumption and portfolio decisions depend on both risk aversion and the elasticity of intertemporal substitution. Only in the case where the investment opportunity set is constant, is the optimal portfolio weight independent of the elasticity of intertemporal substitution, though even in this case the consumption decision depends on both risk aversion and elasticity of intertemporal substitution.

Keywords: Intertemporal optimization and decision making