Lifetime asset allocation with long run risk and time various risk aversion

Abstract

We propose in this article an optimal lifetime asset allocation model in which we simultaneously consider two important stylized facts, long-run risk and time-varying risk aversion. Our model also accounts for the uncertainty and correlation of long-run returns and volatility. Based on American Consumer Expenditure Survey data and macroeconomic data, we have three main findings. First, individual’s risk attitude roughly rises with age, and it has a significant effect on the individual’s best asset allocation choice. Second, two pairs of correlations between the movement of returns and volatility impact an individual’s choice. In the long run, individuals may take the comovement of returns and volatility into account and adjust their optimal investment strategy. The effects of the adjustment term are determined by the direction and strength of the correlations. Third, the economy has a clear business cycle path, and the optimal fraction of risky assets in portfolio vary within a wide range when the risk premium is high during one’s lifetime. We further, based on our data and parameters, perform a simulation to identify the path of the optimal investment strategy. The result implies that individuals and households with lifetime investments such as pension funds should take risk preferences variation into account, and this is especially for older individuals.