External Habit Persistence and Individual Portfolio Choice

Timothy K. Chue ()
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Timothy K. Chue: School of Accounting and Finance, Faculty of Business, Hong Kong Polytechnic University, Hung Hom, Kowloon, Hong Kong SAR, China

JRFM, 2025, vol. 18, issue 10, 1-10

Abstract: This paper shows that a common form of external habit persistence, despite having much success in asset pricing, implies an extreme degree of conformity in investors’ portfolio choice. If an investor with this utility function uses US aggregate consumption as her external habit benchmark, she has to hold all non-redundant securities contained in the US aggregate wealth portfolio. Even for an investor who uses the average consumption of a more narrowly-defined community as her benchmark, she is still required to hold non-zero positions in all (non-redundant) individual stocks held by any other member of the community. If markets are incomplete, even if an individual investor holds a financial portfolio that conforms perfectly with that associated with the external habit benchmark, it is still impossible for the investor to ensure that consumption exceeds habit in all states of the world. Because of this implication, this form of external habit is unlikely to describe the preferences of individual investors —notwithstanding its success as a model for the representative agent in asset pricing.

Keywords: portfolio conformity; external habit persistence; difference model; portfolio choice; incomplete markets (search for similar items in EconPapers)
JEL-codes: C E F2 F3 G (search for similar items in EconPapers)
Date: 2025
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