Consumption and Portfolio Choice under Internal Multiplicative Habit Formation

Servaas van Bilsen, A. Lans Bovenberg and Roger Laeven

Journal of Financial and Quantitative Analysis, 2020, vol. 55, issue 7, 2334-2371

Abstract: This paper explores the optimal consumption and investment behavior of an individual who derives utility from the ratio between his consumption and an endogenous habit. We obtain closed-form policies under general utility functionals and stochastic investment opportunities by developing a nontrivial linearization to the budget constraint. This enables us to explicitly characterize how habit formation affects the marginal propensity to consume and optimal stock–bond investments. We also show that in a setting that combines habit formation with Epstein–Zin utility, consumption no longer grows at unrealistically high rates at high ages and investments in risky assets decrease.

Date: 2020
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Persistent link: https://EconPapers.repec.org/RePEc:cup:jfinqa:v:55:y:2020:i:7:p:2334-2371_9

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