Asset Allocation and Consumption Choices of the Representative Agent with External Habit Formation*

Abstract

In this paper, we examine the asset allocation and consumption policy of the investor with habit formation, given a set of publicly available information. We use time-separable preferences as a benchmark for comparing decisions made by an agent with habit formation. We find that external habit combined with the available information plays a prominent role in both asset allocation and consumption choices for the agent with habit. Force of habit discriminates the consumption policy with habit formation from that with time-separable preferences. The influence of external habit is found to be more pronounced and economically substantial on consumption choice than on asset allocation. In addition, we find that the intertemporal hedging demand of the agent varies considerably depending on instruments used and the investment horizon. Moreover, augmented instrument variable sets guide the agent with external habit to adopt an intertemporal hedging position that is contrary to that taken by the agent with time-separable preferences; this might seem counterintuitive but might be sensible advice when business downturn is anticipated. The degree of time nonseparability accents the external habit on the consumption policy rather than the portfolio policy.