Working Paper: CEPR ID: DP4853
Authors: Francisco J. Gomes; Alexander Michaelides
Abstract: We show that a life cycle model with realistically calibrated uninsurable labour income risk and moderate risk aversion can simultaneously match stock market participation rates and asset allocation decisions conditional on participation. The key ingredients of the model are Epstein-Zin preferences, a fixed stock market entry cost, and moderate heterogeneity in risk aversion. Households with low risk aversion smooth earnings shocks with a small buffer stock of assets, and consequently most of them (optimally) never invest in equities. Therefore, the marginal stockholders are (endogenously) more risk averse, and as a result they do not invest their portfolios fully in stocks.
Keywords: lifecycle models; liquidity constraints; portfolio choice; preference heterogeneity; stock market participation; uninsurable labour income risk
JEL Codes: G11
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| risk aversion (D81) | stock market participation (G10) |
| risk aversion (D81) | wealth accumulation (E21) |
| wealth accumulation (E21) | stock market participation (G10) |
| risk aversion (D81) | asset allocation (G11) |
| fixed entry cost (G31) | stock market participation (G10) |
| risk aversion (D81) | under-investment in equities (G31) |