Long-Run Consumption Risk and Asset Allocation under Recursive Utility and Rational Inattention

Abstract

We study the portfolio decision of a household with limited information-processing capacity in a setting with recursive utility, which has two key features. First, intertemporal substitution and risk aversion are disentangled. Second, the household has a preference for the timing of the resolution of uncertainty. We find that rational inattention combined with a preference for early resolution of uncertainty leads to a significant drop in the share of portfolios held in risky assets, even when the departure from standard expected utility with rational expectations is small. In addition, we show that RI increases the implied equity premium because inattentive investors with recursive utility face greater long-run risk and thus require higher compensation in equilibrium. Our results are robust to the presence of nontradable labor income.