Optimal Life-Cycle Asset Allocation: Understanding the Empirical Evidence

65 Pages Posted: 11 May 2005

See all articles by Francisco Gomes

Francisco Gomes

London Business School

Alexander Michaelides

Imperial College Business School; Centre for Economic Policy Research (CEPR)

Multiple version iconThere are 2 versions of this paper

Date Written: January 2005

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, a fixed stock market entry cost, and moderate heterogeneity in risk aversion. Households with low risk aversion smooth earnings shocks with a small buffer stock of assets, and consequently most of them (optimally) never invest in equities. Therefore, the marginal stockholders are (endogenously) more risk averse, and as a result they do not invest their portfolios fully in stocks.

Keywords: Life-cycle models, portfolio choice, preference heterogeneity, liquidity constraints, stock market participation, uninsurable labor income risk

JEL Classification: G11

Suggested Citation

Gomes, Francisco and Michaelides, Alexander, Optimal Life-Cycle Asset Allocation: Understanding the Empirical Evidence (January 2005). CEPR Discussion Paper No. 4853. Available at SSRN: https://ssrn.com/abstract=721587

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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