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Optimal Life-Cycle Asset Allocation: Understanding the Empirical Evidence




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    • Francisco Gomes is from the London Business School; Alexander Michaelides is from the London School of Economics and CEPR. We thank Viral Acharya, Orazio Attanasio, Ravi Bansal, Michael Brennan, Joao Cocco, Pierre Collin-Dufresne, Steve Davis, Karen Dynan, Bill Dupor, Lorenzo Forni, Joao Gomes, Rick Green, Luigi Guiso, Michael Haliassos, Burton Hollifield, Urban Jermann, Deborah Lucas, Pascal Maenhout, Monica Paiella, Valery Polkovnichenko, Ken Singleton, Nicholas Souleles, Harald Uhlig, Raman Uppal, Annette Vissing-Jørgensen, Tan Wang, Paul Willen, Amir Yaron, Steve Zeldes, Harold Zhang, two anonymous referees, and seminar participants at Carnegie Mellon, Columbia, the Ente-Einaudi Center, the Federal Reserve Board, H.E.C., Leicester, LBS, LSE, Tilburg, UCL, UNC Chapel Hill, Wharton, the 2002 NBER Summer Institute, MFS and SED meetings for helpful comments. Previous versions of this paper have circulated with the title: “Life-Cycle Asset Allocation: A Model with Borrowing Constraints, Uninsurable Labor Income Risk and Stock Market Participation Costs.” We are responsible for any remaining errors.


We show that a life-cycle 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.