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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
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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.

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 

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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.

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