Nber Working Paper Series Consumption Smoothing and Portfolio Rebalancing: the Effects of Adjustment Costs

This paper studies the dynamics of portfolio rebalancing and consumption smoothing in the presence of non-convex portfolio adjustment costs. The goal is to understand a household's response to income and return shocks. The model includes the choice of two assets: one riskless without adjustment costs and a second risky asset with adjustment costs. With these multiple assets, a household can buffer some income fluctuations through the asset without adjustment costs and engage in costly portfolio rebalancing less frequently. We estimate both preference parameters and portfolio adjustment costs. The estimates are used for evaluating consumption smoothing and portfolio adjustment in the face of income and return shocks. Yosef Bonaparte Robert Day School of Economics and Finance Claremont McKenna College 500 East Ninth Street Claremont, CA 91711-6400 [email protected] Russell Cooper Department of Economics European University Institute via della Piazzola, 43 Firenze, 50133 ITALY and University of Texas and also NBER [email protected] Guozhong Zhu Guanghua School of Management Peking University Beijing, China [email protected] Consumption Smoothing and Portfolio Rebalancing: The Effects of Adjustment Costs∗ Yosef Bonaparte†and Russell Cooper‡and Guozhong Zhu§