Working Paper: CEPR ID: DP3868
Authors: Francisco J. Gomes; Alex Michaelides
Abstract: Motivated by the success of internal habit formation preferences in explaining asset-pricing puzzles, we introduce these preferences in a life-cycle model of consumption and portfolio choice with liquidity constraints, undiversifiable labour income risk and stock-market participation costs. In contrast to the initial motivation, we find that the model is not able to simultaneously match two very important stylized facts: a low stock market participation rate, and moderate equity holdings for those households that do invest in stocks. Habit formation increases wealth accumulation because the intertemporal consumption-smoothing motive is stronger. As a result, households start participating in the stock market very early in life, and invest their portfolios almost fully in stocks. Therefore, we conclude that, with respect to its ability to match the empirical evidence on asset allocation behaviour, the internal habit formation model is dominated by its time-separable utility counterpart.
Keywords: Habit Formation; Lifecycle; Asset Allocation; Liquidity Constraints; Stock Market Participation Costs; Uninsurable Labour Income Risk
JEL Codes: E21; G11
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| internal habit formation (D10) | increased wealth accumulation (E21) |
| increased wealth accumulation (E21) | early stock market participation (G14) |
| internal habit formation (D10) | early stock market participation (G14) |
| habit formation model (C92) | counterfactual prediction of stock market participation (G17) |