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

I’m not an EMH or modern financier but this might worry some of those guys, “one of the major drivers of households portfolio allocation seems to be inertia”.

Click Here To Read Do Wealth Fluctuations Generate Time-Varying Risk Aversion?

Abstract (Brunnermeier & Nagel Via Princeton)

We use data from the PSID to investigate how households portfolio alloca- tions change in response to wealth fuctuations. Persistent habits, consumption commitments, and subsistence levels can generate time-varying risk aversion with the consequence that when the level of liquid wealth changes, the proportion a household invests in risky assets should also change in the same direction. In contrast, our analysis shows that the share of liquid assets that households invest in risky assets is not a¤ected by wealth changes. Instead, one of the major drivers of households portfolio allocation seems to be inertia: households rebalance only very slowly following inflows and outflows or capital gains and losses.

Discussion/Conclusions (Brunnermeier & Nagel Via Princeton)

Summing up, our evidence shows that the e¤ect of wealth changes on households asset allocation predicted by di¤erence-habit models is absent in microdata. The relationship between wealth and asset allocation seems best described by constant relative risk aversion. However, the large inertia we …nd isnt predicted by constant relative risk aversion models either  at least not without adding frictions.

Our …nding that wealth changes have some impact on stock market entry and exit suggests that changing stock market participation, rather than time-varying individual
risk aversion, could perhaps play a role in the time-variation of risk premia in the aggregate. Wealth changes can induce changes in stock market participation even with
CRRA preferences, if there are some per-period participation costs. But the e¤ect we and does not seem very strong, so it is somewhat questionable whether the magnitudes are big enough to have a signi…cant e¤ect in the aggregate.

Click Here To Read Do Wealth Fluctuations Generate Time-Varying Risk Aversion?