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RFS Advance Access published online on June 22, 2006
Review of Financial Studies, doi:10.1093/rfs/hhl006
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© The Author 2006. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For permissions, please email: journals.permissions@oxfordjournals.org

Article

Life-Cycle Portfolio Choice with Additive Habit Formation Preferences and Uninsurable Labor Income Risk

Valery Polkovnichenko 1 *
1 Finance Department, Carlson School of Management, University of Minnesota, 3-122 CSOM, 312 19-th Avenue South, Minneapolis, MN 55455

* To whom correspondence should be addressed.
Valery Polkovnichenko, E-mail: polkovni{at}umn.edu


  Abstract

This paper explores implications of additive and endogenous habit formation preferences in the context of a life-cycle model of an investor who has stochastic uninsurable labor income. To solve the model, I analytically derive the habit-wealth feasibility constraints and show that they depend on the worst possible path of future labor income and on the habit strength, but not on the probability of the worst income. When there is only a slim chance of a severe income shock, the model implies much more conservative portfolios. The model also predicts that for some low to moderately wealthy households, the portfolio share allocated to stocks increases with wealth. Because of this feature, the model can generate more conservative portfolios for younger than for middle-aged households. The effects of habits on portfolio choice are robust to income smoothing through borrowing or flexible labor supply. One controversial finding is that for high values of the habit strength parameter, usually required for the resolution of asset pricing puzzles in general equilibrium, the life-cycle model predicts counterfactually high wealth accumulation.


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