| Abstract: | This article explores the implications of additive and endogenoushabit formation preferences in the context of a life-cycle modelof an investor who has stochastic uninsurable labor income.To solve the model, I analytically derive the habit-wealth feasibilityconstraints and show that they depend on the worst possiblepath of future labor income and on the habit strength, but noton the probability of the worst income. When there is only aslim chance of a severe income shock, the model implies muchmore conservative portfolios. The model also predicts that forsome low to moderately wealthy households, the portfolio shareallocated to stocks increases with wealth. Because of this feature,the model can generate more conservative portfolios for youngerthan for middle-aged households. The effects of habits on portfoliochoice are robust to income smoothing through borrowing or flexiblelabor supply. One controversial finding is that for high valuesof the habit strength parameter, usually required for the resolutionof asset pricing puzzles in general equilibrium, the life-cyclemodel predicts counterfactually high wealth accumulation. (JEL:G11, G12) |
