DP2823 Portfolio Choice, Liquidity Constraints and Stock Market Mean Reversion

Author(s): Alexander Michaelides
Publication Date: June 2001
Keyword(s): Buffer Stock Saving, Liquidity Constraints, Portfolio Choice, Stock Market Mean Reversion, Stock Market Predictability
JEL(s): E21, G11
Programme Areas: International Macroeconomics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=2823

This Paper solves numerically for the optimal consumption and portfolio choice of an infinitely lived investor facing short sales and borrowing constraints, undiversifiable labour income risk and a predictable time varying equity premium. The investor aggressively times the market while positive correlation between permanent earnings shocks and stock return innovations generates a substantial hedging demand for the riskless asset. Moreover, a speculative increase in savings arises when stock returns are expected to be high and conversely when future returns are expected to be low. Small information/optimization costs can make it optimal for an investor to assume i.i.d excess stock returns, both because liquidity constraints can be frequently binding and because households can smooth idiosyncratic earnings shock using a small buffer stock of wealth.