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RFS Advance Access originally published online on February 10, 2005
Review of Financial Studies 2005 18(2):491-533; doi:10.1093/rfs/hhi017
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The Review of Financial Studies Vol. 18, No. 2 © 2005 The Society for Financial Studies; all rights reserved.

Consumption and Portfolio Choice over the Life Cycle

João F. Cocco
London Business School

Francisco J. Gomes
London Business School

Pascal J. Maenhout
INSEAD

Address correspondence to: Francisco Gomes, London Business School, Regent's Park, London NW1 4SA, United Kingdom, or e-mail: fgomes{at}london.edu. The usual disclaimer applies

This article solves a realistically calibrated life cycle model of consumption and portfolio choice with non-tradable labor income and borrowing constraints. Since labor income substitutes for riskless asset holdings, the optimal share invested in equities is roughly decreasing over life. We compute a measure of the importance of human capital for investment behavior. We find that ignoring labor income generates large utility costs, while the cost of ignoring only its risk is an order of magnitude smaller, except when we allow for a disastrous labor income shock. Moreover, we study the implications of introducing endogenous borrowing constraints in this incomplete-markets setting.


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