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Life-cycle asset allocation and the peso problem: does ambiguity aversion matter?

Nuno Silva (Economics, Universidade de Coimbra, Coimbra, Portugal) (Economics, CeBER – Center for Business and Economics Research, Coimbra, Portugal)

Review of Behavioral Finance

ISSN: 1940-5979

Article publication date: 27 May 2021

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Abstract

Purpose

The study aims to show that ambiguity aversion exerts a non-negligible effect on the investors' decisions, especially due to the possibility of sharp declines in stock prices.

Design/methodology/approach

The vast majority of previous studies on life-cycle consumption and asset allocation assume that the equity premium is constant. This study evaluates the impact of rare disasters that shift the stock market to a low return state on investors' consumption and portfolio decisions. The author assumes that investors are averse to ambiguity relative to the current state of the economy and must incur a per period cost to participate in the stock market and solve their optimal consumption and asset allocation problem using dynamic programming.

Findings

The results show that most young investors choose not to invest in stocks because they have low accumulated wealth and the potential return from their stock market investments would not cover the participation costs. Furthermore, ambiguity-averse investors hold considerably fewer stocks throughout their lifetime than ambiguity-neutral ones. The fraction of wealth invested in stocks over the typical consumer's life is hump-shaped: it is low for a young individual, peaks at his early 30s and then decreases until his retirement age.

Originality/value

To the best of the author’s knowledge, this is the first study that assesses the impact of negative stock price jumps on the optimal portfolio of an ambiguity-averse investor.

Keywords

Acknowledgements

Funding: This study was supported by CeBER R&D unit funded by national funds through FCT – Fundação para a Ciência e a Tecnologia, I.P., project UIDB/05037/2020.

Citation

Silva, N. (2021), "Life-cycle asset allocation and the peso problem: does ambiguity aversion matter?", Review of Behavioral Finance, Vol. ahead-of-print No. ahead-of-print. https://doi.org/10.1108/RBF-11-2020-0297

Publisher

:

Emerald Publishing Limited

Copyright © 2021, Emerald Publishing Limited

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