Habit Formation from Correlation Aversion

Kenneth C. Lichtendahl (), Raul O. Chao () and Samuel E. Bodily ()
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Kenneth C. Lichtendahl: Darden School of Business, University of Virginia, Charlottesville, Virginia 22903
Raul O. Chao: Darden School of Business, University of Virginia, Charlottesville, Virginia 22903
Samuel E. Bodily: Darden School of Business, University of Virginia, Charlottesville, Virginia 22903

Operations Research, 2012, vol. 60, issue 3, 625-637

Abstract: Making plans about how much to consume and how much to invest in risky assets over an uncertain lifetime is a fundamental economic challenge. The leading models of this planning problem use either additive or habit-forming preferences. For the most part, these models assume an individual is either correlation neutral or correlation seeking in consumption, respectively. In this paper, we introduce two habit-forming, correlation-averse preference models. With these preferences, we find closed-form solutions to the classic consumption and portfolio planning problem. Our solutions recommend that a correlation-averse decision maker follow a habit in their consumption plans. While such habits traditionally have been associated with correlation-seeking preferences, our model leads to consumption habits from correlation-averse preferences.

Keywords: decision analysis; multiattribute utility; stochastic dynamic programming; consumption and portfolio planning (search for similar items in EconPapers)
Date: 2012
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Citations: View citations in EconPapers (2)

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