Life Cycle Consumption and Portfolio Choice with Additive Habit Formation Preferences and Uninsurable Labor Income Risk

Representative agent asset pricing models with habit formation preferences do not generate implications for the behavior of individual agents. To explore these implications , I consider a life cycle model of consumption, savings and portfolio allocation for a household with additive and endogenous habit formation preferences. To solve the model, I characterize analytically the boundary of admissible habit–wealth region. This boundary depends on the worst possible path of future labor income and on the habit strength, but not on the probability of the worst path. The wealth accumulated in excess of the boundary and the habit level jointly determine the optimal savings and portfolio allocation. Consistent with stylized facts, the model predicts less conservative portfolios for households with higher wealth/income. When there is only a slim chance of a severe income shock, the model implies substantially more conservative portfolios than without such a disaster state. Due to the life cycle variation in wealth (risk aversion), the model can generate more conservative portfolios for younger households. A controversial finding is that for the high values of habit strength parameter, usually required for the resolution of asset pricing puzzles in equilibrium models, the life cycle model predicts excessive wealth accumulation.