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Optimal Life‐Cycle Asset Allocation: Understanding the Empirical Evidence
Author(s) -
GOMES FRANCISCO,
MICHAELIDES ALEXANDER
Publication year - 2005
Publication title -
the journal of finance
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 18.151
H-Index - 299
eISSN - 1540-6261
pISSN - 0022-1082
DOI - 10.1111/j.1540-6261.2005.00749.x
Subject(s) - economics , risk aversion (psychology) , asset allocation , earnings , shareholder , stock market , stock (firearms) , capital asset pricing model , financial economics , expected utility hypothesis , microeconomics , econometrics , finance , portfolio , mechanical engineering , paleontology , corporate governance , horse , engineering , biology
We show that a life‐cycle model with realistically calibrated uninsurable labor 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.