Life-Cycle Portfolio Choice with Additive Habit Formation Preferences and Uninsurable Labor Income Risk

Posted: 29 Feb 2008

See all articles by Valery Polkovnichenko

Valery Polkovnichenko

Board of Governors of the Federal Reserve System

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Date Written: January 2007

Abstract

This article explores the implications of additive and endogenous habit formation preferences in the context of a life-cycle model of an investor who has stochastic uninsurable labor income. To solve the model, I analytically derive the habit-wealth feasibility constraints and show that they depend on the worst possible path of future labor income and on the habit strength, but not on the probability of the worst income. When there is only a slim chance of a severe income shock, the model implies much more conservative portfolios. The model also predicts that for some low to moderately wealthy households, the portfolio share allocated to stocks increases with wealth. Because of this feature, the model can generate more conservative portfolios for younger than for middle-aged households. The effects of habits on portfolio choice are robust to income smoothing through borrowing or flexible labor supply. One controversial finding is that for high values of the habit strength parameter, usually required for the resolution of asset pricing puzzles in general equilibrium, the life-cycle model predicts counterfactually high wealth accumulation. (JEL: G11, G12)

Suggested Citation

Polkovnichenko, Valery, Life-Cycle Portfolio Choice with Additive Habit Formation Preferences and Uninsurable Labor Income Risk (January 2007). The Review of Financial Studies, Vol. 20, Issue 1, pp. 83-124, 2007, Available at SSRN: https://ssrn.com/abstract=1093505 or http://dx.doi.org/10.1093/rfs/hhl006

Valery Polkovnichenko (Contact Author)

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

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