Portfolio Choice, Liquidity Constraints and Stock Market Mean Reversion

Abstract

This paper solves numerically for the optimal consumption and portfolio choice of a long-horizon investor facing short-sales and borrowing constraints, undiversifiable labor income risk and a predictable time varying equity premium. The investor pursues aggressive market timing strategies; a speculative increase in savings arises when stock returns are expected to be high and conversely when future returns are expected to be low. Positive correlation between permanent earnings shocks and stock return innovations generates a substantial hedging demand for the riskless asset for risk averse investors. Hedging demands arising from the correlation of permanent earnings shocks and the factor innovation and from the correlation between the factor innovation and the stock market shock are evaluated and are found to be small in magnitude. Conversely, asset demand changes that arise from relaxing the liquidity constraints are substantial.