Do Fluctuations in Wealth Generate Time-Varying Risk Aversion? Micro-Evidence on Individuals’ Asset Allocation

One explanation for the apparent " excess volatility " and predictability of stock returns is that fluctuations in wealth generate counter-cyclical variation in risk aversion, as, for example, in models with additive habit formation preferences. While these representative-agent models have some success in matching moments of aggregate variables, it is not clear yet what their micro-foundations are. In an effort to provide evidence on this issue, we analyze two decades of micro data from the PSID and CEX surveys to estimate how a typical household's willingness to bear stock market risk responds to wealth shocks. Our results show that there is no positive relationship between changes in household wealth and the share of financial wealth allocated to stocks. If anything, the relationship is slightly negative. Instead, we find that the dominant influence on individuals' asset allocation is inertia: Following a capital gain or loss or in-and outflows of financial wealth, households do very little rebalancing. But even controlling for this inertia, there is no economically significant wealth effect on stock holdings. Overall, our results suggest that the apparent negative relationship between wealth changes and risk aversion at the aggregate level is not driven by a similar relationship at the household level. Moreover, capital gains or losses on stocks appear to play a special role in explaining household asset allocation.