Optimal Rules of Thumb for Consumption and Portfolio Choice

Authors


  • I am sincerely grateful for the constructive comments of two anonymous referees and Wouter Den Haan, the editor. In addition, I thank Ralph Bradburd, Bill Gentry, Ken Kuttner, Joachim Winter, Steve Zeldes and seminar participants at Williams College and Columbia Business School for helpful comments and discussion. All errors are my own.

Corresponding author: David A. Love, Department of Economics, Williams College, Williamstown, MA 01267, USA. E-mail: david.love@williams.edu.

Abstract

Conventional rules of thumb represent simple, but inefficient, alternatives to dynamic programming solutions. This article seeks an intermediate ground by developing a framework for selecting optimal rules of thumb, where rules of thumb are defined as simple functions of state variables. In the case of portfolio choice, optimal linear age rules lead to only modest welfare losses relative to the dynamic programming solution, while a linear rule based on the ratio of financial wealth to total lifetime resources performs even better. Consumption rules generate larger welfare losses but an effective rule is to consume 70–80% of annuitised lifetime wealth.

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