Portfolio Choice, Liquidity Constraints and Stock Market Mean Reversion

Alexander Michaelides

No 115, Computing in Economics and Finance 2001 from Society for Computational Economics

Abstract: This paper solves numerically for the optimal consumption and portfolio choice of an infinitely lived investor facing short-sales and borrowing constraints, undiversifiable labor income risk and a predictable time varying equity premium. The investor aggressively times the market while positive correlation between permanent earnings shocks and stock return innovations generates a substantial hedging demand for the riskless asset. Moreover, a speculative increase in savings arises when stock returns are expected to be high and conversely when future returns are expected to be low. Small information/optimization costs can make it optimal for an investor to assume i.i.d. excess stock returns both because liquidity constraints can be frequently binding and because households can smooth idiosyncratic earnings shocks using a small buffer stock of wealth.

Keywords: Portfolio Choice; Liquidity Constraints; Buffer Stock Saving; Stock Market Mean Reversion; Stock Market Predictability (search for similar items in EconPapers)
JEL-codes: E21 G11 (search for similar items in EconPapers)
Date: 2001-04-01
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Citations: View citations in EconPapers (8)

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Working Paper: Portfolio Choice, Liquidity Constraints and Stock Market Mean Reversion (2001)
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