Rational Inattention, Long-Run Consumption Risk, and Portfolio Choice

38 Pages Posted: 13 Jul 2006 Last revised: 14 Feb 2009

Date Written: August 23, 2008

Abstract

This paper explores how the introduction of rational inattention (RI) -- that agents process information subject to finite channel capacity -- affects optimal consumption and investment decisions in an otherwise standard intertemporal model of portfolio choice. We first explicitly derive optimal consumption and portfolio rules under RI and then show that introducing RI reduces the optimal share of savings invested in the risky asset because inattentive investors face greater long-run consumption risk. We also show that the investment horizon matters for portfolio allocation in the presence of RI, even if investment opportunities are constant and the utility function of investors is constant relative risk aversion. Second, after aggregating across investors, we show that introducing RI can better explain the observed joint dynamics of aggregate consumption and the asset return. Finally, we show that RI increases the implied equity premium because investors under RI face greater long-run consumption risk and thus require higher compensation in equilibrium.

Keywords: Rational Inattention, Long-term Consumption Decisions, Portfolio Choice, the Equity Premium

JEL Classification: E44, G11, G12

Suggested Citation

Luo, Yulei, Rational Inattention, Long-Run Consumption Risk, and Portfolio Choice (August 23, 2008). Available at SSRN: https://ssrn.com/abstract=913781 or http://dx.doi.org/10.2139/ssrn.913781

Yulei Luo (Contact Author)

University of Hong Kong ( email )

Pokfulam Road
Hong Kong, HK
China

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