Time-consistent lifetime portfolio selection under smooth ambiguity

Abstract

<p style='text-indent:20px;'>This paper studies the optimal consumption, life insurance and investment problem for an income earner with uncertain lifetime under smooth ambiguity model. We assume that risky assets have unknown market prices that result in ambiguity. The individual forms his belief, that is, the distribution of market prices, according to available information. His ambiguity attitude, which is similar to the risk attitude described by utility function <inline-formula><tex-math id="M1">\begin{document}$ U $\end{document}</tex-math></inline-formula>, is represented by an ambiguity preference function <inline-formula><tex-math id="M2">\begin{document}$ \phi $\end{document}</tex-math></inline-formula>. Under the smooth ambiguity model, the problem becomes time-inconsistent. We derive the extended Hamilton-Jacobi-Bellman (HJB) equation for the equilibrium value function and equilibrium strategy. Then, we obtain the explicit solution for the equilibrium strategy when both <inline-formula><tex-math id="M3">\begin{document}$ U $\end{document}</tex-math></inline-formula> and <inline-formula><tex-math id="M4">\begin{document}$ \phi $\end{document}</tex-math></inline-formula> are power functions. We find that a more risk- or ambiguity-averse individual will consume less, buy more life insurance and invest less. Moreover, we find that the Tobin-Markowitz separation theorem is no longer applicable when ambiguity attitude is taken into consideration. The investment strategy will change with the characteristics of the decision maker, such as risk attitude, ambiguity attitude and age.</p>