Portfolio Choice with Internal Habit Formation: A Life-Cycle Model with Uninsurable Labour Income Risk

Francisco Gomes () and Alexander Michaelides

No 3868, CEPR Discussion Papers from C.E.P.R. Discussion Papers

Abstract: Motivated by the success of internal habit formation preferences in explaining asset-pricing puzzles, we introduce these preferences in a life-cycle model of consumption and portfolio choice with liquidity constraints, undiversifiable labour income risk and stock-market participation costs. In contrast to the initial motivation, we find that the model is not able to simultaneously match two very important stylized facts: a low stock market participation rate, and moderate equity holdings for those households that do invest in stocks. Habit formation increases wealth accumulation because the intertemporal consumption-smoothing motive is stronger. As a result, households start participating in the stock market very early in life, and invest their portfolios almost fully in stocks. Therefore, we conclude that, with respect to its ability to match the empirical evidence on asset allocation behaviour, the internal habit formation model is dominated by its time-separable utility counterpart.

Keywords: habit formation; life-cycle asset allocation; liquidity constraints; stock market participation costs; uninsurable labour income risk (search for similar items in EconPapers)
JEL-codes: E21 G11 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-cfn
Date: 2003-04
View list of references View citations in EconPapers

Downloads: (external link)
http://www.cepr.org/pubs/dps/DP3868.asp (application/pdf)
CEPR Discussion Papers are free to download for our researchers, subscribers and members. If you fall into one of these categories but have trouble downloading our papers, please contact us at subscribers@cepr.org

Related works:
Journal Article: Portfolio Choice With Internal Habit Formation: A Life-Cycle Model With Uninsurable Labor Income Risk (2003)
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: http://EconPapers.repec.org/RePEc:cpr:ceprdp:3868

Ordering information: This working paper can be ordered from
http://www.cepr.org/pubs/dps/DP3868.asp

Access Statistics for this paper

More papers in CEPR Discussion Papers from C.E.P.R. Discussion Papers
Address: Centre for Economic Policy Research, 53--56 Great Sutton Street, London EC1V 0DG
Series data maintained by ().