Hostname: page-component-7dd5485656-wjfd9 Total loading time: 0 Render date: 2025-10-30T23:56:36.511Z Has data issue: false hasContentIssue false
  • English
  • Français

Stock Market Mean Reversion and Portfolio Choice over the Life Cycle

Published online by Cambridge University Press:  15 June 2017

Alexander Michaelides  and
Yuxin Zhang
Get access Rights & Permissions [Opens in a new window]

Abstract

We solve for optimal consumption and portfolio choice in a life-cycle model with short-sales and borrowing constraints; undiversifiable labor income risk; and a predictable, time-varying, equity premium and show that the investor pursues aggressive market timing strategies. Importantly, in the presence of stock market predictability, the model suggests that the conventional financial advice of reducing stock market exposure as retirement approaches is correct on average, but ignoring changing market information can lead to substantial welfare losses. Therefore, enhanced target-date funds (ETDFs) that condition on expected equity premia increase welfare relative to target-date funds (TDFs). Out-of-sample analysis supports these conclusions.

Information

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 52 , Issue 3 , June 2017 , pp. 1183 - 1209
Copyright
Copyright © Michael G. Foster School of Business, University of Washington 2017 

Access options

Get access to the full version of this content by using one of the access options below. (Log in options will check for institutional or personal access. Content may require purchase if you do not have access.)

Article purchase

Temporarily unavailable

Footnotes

1

This version is preceded by an older working paper titled “Portfolio Choice, Liquidity Constraints and Stock Market Mean Reversion.” We thank an anonymous referee, Nicholas Barberis, Stephen Brown (the editor), John Campbell, John Cochrane, George Constantinides, Steve Davis, Christian Gollier, Francisco Gomes, Michael Haliassos, James Kahn, Martin Lettau, Sydney Ludvigson, Lubos Pastor, Cesare Robotti, Annette Vissing-Jorgensen, Paul Willen, and seminar participants at Athens University of Economics and Business, the 2015 NETSPAR international conference on pensions, the University of Chicago Graduate School of Business, the University of Cyprus, the University of Southampton, the University of Sussex, and the Federal Reserve Bank of New York for many helpful comments.

References

Angerer, X., and Lam, P.. “Income Risk and Portfolio Choice: An Empirical Study.” Journal of Finance, 64 (2009), 1037–1055.CrossRefGoogle Scholar
Balduzzi, P., and Lynch, A. W.. “Transaction Costs and Predictability: Some Utility Cost Calculations.” Journal of Financial Economics, 52 (1999), 47–78.CrossRefGoogle Scholar
Barberis, N.“Investing for the Long Run When Returns Are Predictable.” Journal of Finance, 55 (2000), 225–264.CrossRefGoogle Scholar
Benzoni, L.; Collin-Dufresne, P.; and Goldstein, R.. “Portfolio Choice over the Life-Cycle When the Stock and Labor Markets Are Cointegrated.” Journal of Finance, 62 (2007), 2123–2167.CrossRefGoogle Scholar
Bonaparte, Y.; Korniotis, G.; and Kumar, A.. “Income Hedging and Portfolio Decisions.” Journal of Financial Economics, 113 (2014), 300–324.CrossRefGoogle Scholar
Brandt, M. W.“Estimating Portfolio and Consumption Choice: A Conditional Euler Equations Approach.” Journal of Finance, 54 (1999), 1609–1646.CrossRefGoogle Scholar
Brandt, M. W.; Goyal, A.; Santa-Clara, P.; and Stroud, J. R.. “A Simulation Approach to Dynamic Portfolio Choice with an Application to Learning about Return Predictability.” Review of Financial Studies, 18 (2005), 831–873.CrossRefGoogle Scholar
Brennan, M.; Schwartz, E.; and Lagnado, R.. “Strategic Asset Allocation.” Journal of Economic Dynamics and Control, 21 (1997), 1377–1403.CrossRefGoogle Scholar
Brennan, M., and Xia, Y.. “Dynamic Asset Allocation under Inflation.” Journal of Finance, 57 (2002), 1201–1238.CrossRefGoogle Scholar
Campbell, J. Y.; Chan, Y. L.; and Viceira, L.. “A Multivariate Model of Strategic Asset Allocation.” Journal of Financial Economics, 67 (2003), 41–80.CrossRefGoogle Scholar
Campbell, J. Y.; Cocco, J.; Gomes, F.; Maenhout, P.; and Viceira, L.. “Stock Market Mean Reversion and the Optimal Allocation of a Long-Lived Investor.” European Finance Review, 5 (2001), 269–292.CrossRefGoogle Scholar
Campbell, J. Y., and Viceira, L.. “Consumption and Portfolio Decisions When Expected Returns Are Time Varying.” Quarterly Journal of Economics, 114 (1999), 433–495.CrossRefGoogle Scholar
Carroll, C.“Buffer-Stock Saving and the Life Cycle/Permanent Income Hypothesis.” Quarterly Journal of Economics, 112 (1997), 3–55.CrossRefGoogle Scholar
Cocco, J.; Gomes, F.; and Maenhout, P.. “Consumption and Portfolio Choice over the Life Cycle.” Review of Financial Studies, 18 (2005), 491–533.CrossRefGoogle Scholar
Cocco, J., and Lopes, P.. “Reverse Mortgage Design.” Working Paper, LBS/LSE (2015).Google Scholar
Cooper, R., and Zhu, G.. “Household Finance over the Life-Cycle: What Does Education Contribute?” Review of Economic Dynamics, 20 (2016), 63–89.CrossRefGoogle Scholar
Davidoff, T.“Can High Costs Justify Weak Demand for the Home Equity Conversion Mortgage?” Review of Financial Studies, 28 (2015), 2364–2398.CrossRefGoogle Scholar
Davis, S.; Kubler, F.; and Willen, P.. “Borrowing Costs and the Demand for Equity over the Life Cycle.” Review of Economics and Statistics, 88 (2006), 348–362.CrossRefGoogle Scholar
Deaton, A.“Saving and Liquidity Constraints.” Econometrica, 59 (1991), 1221–1248.CrossRefGoogle Scholar
Donaldson, S.; Kinniry, F.; Aliaga-Diaz, R.; Patterson, A.; and DiJoseph, M.. Vanguard’s Approach to Target-Date Funds. Valley Forge, PA: Vanguard Research (2013).Google Scholar
Epstein, L., and Zin, S.. “Substitution, Risk Aversion, and the Temporal Behavior of Consumption and Asset Returns: A Theoretical Framework.” Econometrica, 57 (1989), 937–969.CrossRefGoogle Scholar
Floden, M.“A Note on the Accuracy of Markov-Chain Approximations to Highly Persistent AR(1) Processes.” Economics Letters, 99 (2008), 516–520.CrossRefGoogle Scholar
Gomes, F., and Michaelides, A.. “Optimal Life-Cycle Asset Allocation: Understanding the Empirical Evidence.” Journal of Finance, 60 (2005), 869–904.CrossRefGoogle Scholar
Gomes, F.; Michaelides, A.; and Polkovnichenko, V.. “Optimal Savings with Taxable and Tax-Deferred Accounts.” Review of Economic Dynamics, 12 (2009), 718–735.CrossRefGoogle Scholar
Haliassos, M., and Michaelides, A.. “Portfolio Choice and Liquidity Constraints.” International Economic Review, 44 (2003), 144–177.CrossRefGoogle Scholar
Heaton, J., and Lucas, D.. “Portfolio Choice in the Presence of Background Risk.” Economic Journal, 110 (2000), 1–26.CrossRefGoogle Scholar
Kim, T. S., and Omberg, E.. “Dynamic Nonmyopic Portfolio Behavior.” Review of Financial Studies, 9 (1996), 141–161.CrossRefGoogle Scholar
Koijen, R.; Nijman, T.; and Werker, B.. “When Can Life Cycle Investors Benefit from Time-Varying Bond Risk Premia?” Review of Financial Studies, 23 (2010), 741–780.CrossRefGoogle Scholar
Lan, C.“An Out-of-Sample Evaluation of Dynamic Portfolio Strategies.” Review of Finance, 19 (2015), 2359–2399.CrossRefGoogle Scholar
Lynch, A., and Tan, S.. “Labor Income Dynamics at Business-Cycle Frequencies: Implications for Portfolio Choice.” Journal of Financial Economics, 101 (2011), 333–359.CrossRefGoogle Scholar
Munk, C., and Sorensen, C.. “Dynamic Asset Allocation with Stochastic Income and Interest Rates.” Journal of Financial Economics, 96 (2010), 433–462.CrossRefGoogle Scholar
Newey, W. K., and West, K. D.. “A Simple, Positive Semi-Definite, Heteroskedasticity and Autocorrelation Consistent Covariance Matrix.” Econometrica, 55 (1987), 703–708.CrossRefGoogle Scholar
Pastor, L., and Stambaugh, R. F.. “Are Stocks Really Less Volatile in the Long Run?” Journal of Finance, 67 (2012), 431–477.CrossRefGoogle Scholar
Pettenuzzo, D.; Timmermann, A.; and Valkanov, R.. “Forecasting Stock Returns under Economic Constraints.” Journal of Financial Economics, 114 (2014), 517–553.CrossRefGoogle Scholar
Tauchen, G.“Finite State Markov-Chain Approximations to Univariate and Vector Autoregressions.” Economics Letters, 20 (1986), 177–181.CrossRefGoogle Scholar
Tauchen, G., and Hussey, R.. “Quadrature-Based Methods for Obtaining Approximate Solutions to Nonlinear Asset Pricing Models.” Econometrica, 59 (1991), 371–396.CrossRefGoogle Scholar
Viceira, L.“Optimal Portfolio Choice for Long-Horizon Investors with Nontradable Labor Income.” Journal of Finance, 55 (2001), 1163–1198.Google Scholar
Vissing-Jorgensen, A.“Limited Asset Market Participation and the Elasticity of Intertemporal Substitution.” Journal of Political Economy, 110 (2002), 825–853.CrossRefGoogle Scholar
Wachter, J.“Optimal Consumption and Portfolio Allocation with Mean-Reverting Returns: An Exact Solution for Complete Markets.” Journal of Financial and Quantitative Analysis, 37 (2002), 63–91.CrossRefGoogle Scholar
Weil, P.“Nonexpected Utility in Macroeconomics.” Quarterly Journal of Economics, 2 (1990), 29–42.CrossRefGoogle Scholar
Xia, Y.“Learning about Predictability: The Effects of Parameter Uncertainty on Dynamic Asset Allocation.” Journal of Finance, 56 (2001), 205–246.CrossRefGoogle Scholar
Supplementary material: File

Michaelides and Zhang supplementary material

Michaelides and Zhang supplementary material

Download Michaelides and Zhang supplementary material(File)
File 172 Bytes