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Discussion Paper Details

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Title: Optimal Life-Cycle Asset Allocation: Understanding the Empirical Evidence

Author(s): Francisco J Gomes and Alexander Michaelides

Publication Date: January 2005

Keyword(s): life-cycle models, liquidity constraints, portfolio choice, preference heterogeneity, stock market participation and uninsurable labour income risk

Programme Area(s): Financial Economics and International Macroeconomics

Abstract: We show that a life cycle model with realistically calibrated uninsurable labour 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.

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Bibliographic Reference

Gomes, F and Michaelides, A. 2005. 'Optimal Life-Cycle Asset Allocation: Understanding the Empirical Evidence'. London, Centre for Economic Policy Research. https://cepr.org/active/publications/discussion_papers/dp.php?dpno=4853