Working Paper: CEPR ID: DP2823
Authors: Alex Michaelides
Abstract: This Paper solves numerically for the optimal consumption and portfolio choice of an infinitely lived investor facing short sales and borrowing constraints, undiversifiable labour 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 shock using a small buffer stock of wealth.
Keywords: Buffer Stock Saving; Liquidity Constraints; Portfolio Choice; Stock Market Mean Reversion; Stock Market Predictability
JEL Codes: E21; G11
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| stock market predictability (G17) | optimal consumption (D10) |
| high expected future returns (G17) | stock allocation (G11) |
| low expected returns (G12) | greater investment in riskless assets (G11) |
| stock return expectations (G17) | savings behavior (D14) |
| liquidity constraints (E41) | savings behavior (D14) |
| expected returns on savings (D14) | substitution effect (D11) |
| labor income risk (J39) | savings and portfolio allocation (G11) |
| labor income shocks (J39) | stock market allocations (G11) |
| liquidity constraints (E41) | aggressive market timing behavior (G14) |