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144
Consumption and portfolio choice over the life cycle
, 2001
"... This paper solves a realistically calibrated lifecycle model of consumption and portfolio choice with uninsurable labor income risk and borrowing constraints. Since labor income substitutes for riskless asset holdings the optimal share invested in equities is roughly decreasing over life. We comput ..."
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Cited by 242 (21 self)
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This paper solves a realistically calibrated lifecycle model of consumption and portfolio choice with uninsurable labor income risk 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 nontradable human capital for investment behavior to find that ignoring labor income generates large utility costs, while the cost of ignoring only its risk is an order of magnitude smaller. We also quantify the utility cost associated with typical heuristics advocated by financial advisors. The issue of portfolio choice over the lifecycle is encountered by every investor. Popular finance books (e.g. Malkiel, 1996) and financial counselors generally give the advice to shift the portfolio composition towards relatively safe assets, such as Tbills, and away from risky stocks as the investor grows older and reaches retirement. But what could be the economic
Asset pricing at the millennium
 Journal of Finance
"... This paper surveys the field of asset pricing. The emphasis is on the interplay between theory and empirical work and on the tradeoff between risk and return. Modern research seeks to understand the behavior of the stochastic discount factor ~SDF! that prices all assets in the economy. The behavior ..."
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Cited by 189 (0 self)
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This paper surveys the field of asset pricing. The emphasis is on the interplay between theory and empirical work and on the tradeoff between risk and return. Modern research seeks to understand the behavior of the stochastic discount factor ~SDF! that prices all assets in the economy. The behavior of the term structure of real interest rates restricts the conditional mean of the SDF, whereas patterns of risk premia restrict its conditional volatility and factor structure. Stylized facts about interest rates, aggregate stock prices, and crosssectional patterns in stock returns have stimulated new research on optimal portfolio choice, intertemporal equilibrium models, and behavioral finance. This paper surveys the field of asset pricing. The emphasis is on the interplay between theory and empirical work. Theorists develop models with testable predictions; empirical researchers document “puzzles”—stylized facts that fail to fit established theories—and this stimulates the development of new theories. Such a process is part of the normal development of any science. Asset pricing, like the rest of economics, faces the special challenge that data are generated naturally rather than experimentally, and so researchers cannot control the quantity of data or the random shocks that affect the data. A particularly interesting characteristic of the asset pricing field is that these random shocks are also the subject matter of the theory. As Campbell, Lo, and MacKinlay ~1997, Chap. 1, p. 3! put it: What distinguishes financial economics is the central role that uncertainty plays in both financial theory and its empirical implementation. The starting point for every financial model is the uncertainty facing investors, and the substance of every financial model involves the impact of uncertainty on the behavior of investors and, ultimately, on mar* Department of Economics, Harvard University, Cambridge, Massachusetts
Junior Can’t Borrow: A New Perspective on the Equity Premium Puzzle, unpublished manuscript
, 1997
"... Ongoing questions on the historical mean and standard deviation of the return on equities and bonds and on the equilibrium demand for these securities are addressed in the context of a stationary, overlappinggenerations economy in which consumers are subject to a borrowing constraint. The key featu ..."
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Cited by 177 (17 self)
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Ongoing questions on the historical mean and standard deviation of the return on equities and bonds and on the equilibrium demand for these securities are addressed in the context of a stationary, overlappinggenerations economy in which consumers are subject to a borrowing constraint. The key feature captured by the OLG economy is that the bulk of the future income of the young consumers is derived from their wages forthcoming in their middle age, while the bulk of the future income of the middleaged consumers is derived from their savings in equity and bonds. The young would like to borrow and invest in equity but the borrowing constraint prevents them from doing so. The middleaged choose to hold a diversified portfolio that includes positive holdings of bonds, and this explains the demand for bonds. Without the borrowing constraint, the young borrow and invest in equity, thereby decreasing the mean equity premium and increasing the rate of interest. I.
Optimal lifecycle asset allocation: understanding the empirical evidence
 JOURNAL OF FINANCE
, 2005
"... We show that a lifecycle 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, ..."
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Cited by 174 (18 self)
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We show that a lifecycle 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. IN THIS PAPER, WE PRESENT A LIFECYCLE ASSET allocation model with intermediate consumption and stochastic uninsurable labor income that provides an explanation for two very important empirical observations: low stock market participation rates in the population as a whole, and moderate equity holdings for stock market participants. Our lifecycle model integrates three main motives that have been identified
Wealth accumulation over the life cycle and precautionary savings
 Journal of Business and Economic Statistics
, 2003
"... This article constructs and simulates a life cycle model of wealth accumulation and estimates the parameters of the utility function (the rate of time preference and the coefficient of risk aversion) by matching the simulated median wealth profiles with those observed in the Panel Study of Income D ..."
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Cited by 144 (5 self)
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This article constructs and simulates a life cycle model of wealth accumulation and estimates the parameters of the utility function (the rate of time preference and the coefficient of risk aversion) by matching the simulated median wealth profiles with those observed in the Panel Study of Income Dynamics and in the Survey of Consumer Finances. The estimates imply a low degree of patience and a high degree of risk aversion. The results are used to study the importance of precautionary savings in explaining wealth accumulation. They imply that wealth accumulation is driven mostly by precautionary motives at the beginning of the life cycle, whereas savings for retirement purposes become significant only closer to retirement. KEY WORDS: Precautionary savings; Simulated method of moments. 1.
Consumption and risk sharing over the life cycle
 Journal of Monetary Economics
, 2004
"... A striking feature of U.S. data on income and consumption is that inequality increases with age. This paper asks if individualspecific earnings risk can provide a coherent explanation. We find that it can. We construct an overlapping generations general equilibrium model in which households face un ..."
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Cited by 135 (7 self)
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A striking feature of U.S. data on income and consumption is that inequality increases with age. This paper asks if individualspecific earnings risk can provide a coherent explanation. We find that it can. We construct an overlapping generations general equilibrium model in which households face uninsurable earnings shocks over the course of their lifetimes. Earnings inequality is exogenous and is calibrated to match data from the U.S. Panel Study on Income Dynamics. Consumption inequality is endogenous and matches well data from the U.S. Consumer Expenditure Survey. The total risk households face is decomposed into that realized before entering the labor market and that realized throughout the working years. In welfare terms, the latter is found to be more important than the former.
Asset Pricing with Heterogeneous Consumers and Limited Participation: Empirical Evidence
 JOURNAL OF POLITICAL ECONOMY
, 1999
"... The Euler equations of consumption are tested on the household consumption of nondurables and services, reconstructed from the CEX database. The estimated relative risk aversion coefficient of the representative household decreases, and the estimated unexplained mean equity premium decreases, as inf ..."
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Cited by 117 (10 self)
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The Euler equations of consumption are tested on the household consumption of nondurables and services, reconstructed from the CEX database. The estimated relative risk aversion coefficient of the representative household decreases, and the estimated unexplained mean equity premium decreases, as infra marginal asset holders are eliminated from the sample. These results provide evidence of limited capital market participation. The estimated unexplained mean equity premium decreases when the assumption of complete consumption insurance is relaxed. The estimated correlation between the equity premium and the crosssectional variance of the households' consumption growth is negative, as required, if the relaxation of market completeness is to contribute towards the explanation of the premium. The overall evidence from asset prices in favor of relaxing the assumption of complete consumption insurance is weak. An extensive Monte Carlo investigation highlights the relationship between the economic implications of limited participation and the resulting statistical properties of commonly used test statistics. The simulation results provide direct evidence relating observation error in consumption and the resulting smallsample properties of the test statistics.
Catching Up with the Joneses: Heterogeneous Preferences and the Dynamics of Asset Prices
, 2001
"... ..."
Idiosyncratic risk matters
 Journal of Finance
, 2003
"... This paper takes a new look at the tradeoff between risk and return in the stock market. We find a significant positive relation between average stock variance and the return on the market. There is, therefore, a tradeoff between risk and return in the stock market, except that risk is measured as t ..."
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Cited by 108 (6 self)
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This paper takes a new look at the tradeoff between risk and return in the stock market. We find a significant positive relation between average stock variance and the return on the market. There is, therefore, a tradeoff between risk and return in the stock market, except that risk is measured as total risk, including idiosyncratic risk, rather than only systematic risk. Further, we find that the variance of the market by itself has no forecasting power for the market return. These relations persist after we control for macroeconomic variables known to forecast the stock market. We show that idiosyncratic risk explains most of the variation of average stock risk through time and it is idiosyncratic risk that drives the forecastability of the stock market.
Cyclical Dynamics in Idiosyncratic Labor Market Risk
 Journal of Political Economy, University of Chicago Press
, 2004
"... Is individual labor income more risky in recessions? This is a difficult question to answer because existing panel data sets are so short. To address this problem, we develop a generalized method of moments estimator that conditions on the macroeconomic history that each member of the panel has expe ..."
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Cited by 100 (10 self)
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Is individual labor income more risky in recessions? This is a difficult question to answer because existing panel data sets are so short. To address this problem, we develop a generalized method of moments estimator that conditions on the macroeconomic history that each member of the panel has experienced. Variation in the crosssectional variance between households with differing macroeconomic histories allows us to incorporate business cycle information dating back to 1930, even though our data do not begin until 1968. We implement this estimator using householdlevel labor earnings data from the Panel Study of Income Dynamics. We estimate that idiosyncratic risk is (i) highly persistent, with an annual autocorrelation coefficient of 0.95, and (ii) strongly countercyclical, with a conditional standard