Discussion Paper Details

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

Author(s): Francisco J Gomes and Alexander Michaelides

Publication Date: April 2003

Keyword(s): habit formation, life-cycle asset allocation, liquidity constraints, stock market participation costs and uninsurable labour income risk

Programme Area(s): Financial Economics

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.

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Bibliographic Reference

Gomes, F and Michaelides, A. 2003. 'Portfolio Choice with Internal Habit Formation: A Life-Cycle Model with Uninsurable Labour Income Risk'. London, Centre for Economic Policy Research.