Consumption and Portfolio Choice under Internal Multiplicative Habit Formation

Abstract

This paper explores the optimal consumption and investment behavior of an individual who derives utility from the ratio between his consumption and an endogenous habit. We obtain closed-form policies under general utility functionals and stochastic investment opportunities by developing a nontrivial linearization to the budget constraint. This enables us to explicitly characterize how habit formation affects the marginal propensity to consume and optimal stock–bond investments. We also show that in a setting that combines habit formation with Epstein–Zin utility, consumption no longer grows at unrealistically high rates at high ages and investments in risky assets decrease.