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 , portfolio choice , preference heterogeneity , liquidity constraints , stock market participation , uninsurable labour income risk

JEL(s): G11

Programme Areas: Financial Economics , International Macroeconomics

Link to this Page: www.cepr.org/pubs/dps/DP4853.asp

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.