Consumption and portfolio choice under internal multiplicative habit formation

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Abstract

This paper explores the optimal consumption and investment behavior of an individual who derives utility from the ratio between his consumption and an endogenous habit. We obtain closed-form policies under general utility functionals and stochastic investment opportunities by developing a nontrivial linearization to the budget constraint. This enables us to explicitly characterize how habit formation affects the marginal propensity to consume and optimal stock–bond investments. We also show that in a setting that combines habit formation with Epstein–Zin utility, consumption no longer grows at unrealistically high rates at high ages and investments in risky assets decrease.
Original languageEnglish
Pages (from-to)2334 - 2371
JournalJournal of Financial and Quantitative Analysis
Volume55
Issue number7
DOIs
Publication statusPublished - 1 Nov 2020

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