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, 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