Ambiguous Consumption and Asset Allocation with Unknown Markovian Income Growth

Yulei Luo (), Jun Nie () and Haijun Wang ()
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Yulei Luo: Faculty of Business and Economics, University of Hong Kong, Hong Kong
Jun Nie: EMS and IAS, Wuhan University
Haijun Wang: School of Mathematics and Shanghai Key Laboratory of Financial Information Technology, Shanghai University of Finance and Economics, China.

Annals of Economics and Finance, 2023, vol. 24, issue 2, 237-275

Abstract: This paper constructs a recursive utility version of a canonical Merton (1971) model with uninsurable labor income and unknown income growth to study how the interaction between two types of uncertainty due to ignorance affects strategic consumption-portfolio rules and precautionary savings. Specifically, after solving the model explicitly, we theoretically and quantitatively explore (i) how these ignorance-induced uncertainties interact with intertemporal substitution, risk aversion, and the correlation between the equity return and labor income, and (ii) how they jointly affect strategic asset allocation, precautionary savings, and the equilibrium asset returns. Furthermore, we use data to test our model's predictions on the relationship between ignorance and asset allocation and quantitatively show that the interaction between the two types of uncertainty is the key to explain the data. Finally, we find that the welfare costs of ignorance can be very large.

Keywords: Ignorance; Unknown Income Growth; Induced Uncertainty; Strategic Asset Allocation (search for similar items in EconPapers)
JEL-codes: C61 D81 E21 (search for similar items in EconPapers)
Date: 2023
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Persistent link: https://EconPapers.repec.org/RePEc:cuf:journl:y:2023:v:24:i:2:luoniewang

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