DP4853 Optimal Life-Cycle Asset Allocation: Understanding the Empirical Evidence

Author(s): Francisco J Gomes, Alexander Michaelides
Publication Date: January 2005
Keyword(s): life-cycle models, liquidity constraints, portfolio choice, preference heterogeneity, stock market participation, uninsurable labour income risk
JEL(s): G11
Programme Areas: International Macroeconomics, Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=4853

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.