Stock market mean reversion and portfolio choice over the life cycle

We solve for optimal consumption and portfolio choice in a life-cycle model with short-sales and borrowing constraints, undiversi?able labor income risk and a predictable, time-varying, equity premium and show that the investor pursues aggressive market timing strategies. Importantly, in the presence of stock market predictability, the model suggests that the conventional fi?nancial advice of reducing stock market exposure as retirement approaches is correct on average, but ignoring changing market information can lead to substantial welfare losses. Therefore, enhanced target-date funds (ETDFs) that condition on expected equity premia increase welfare relative to target-date funds (TDFs).

Netspar, Network for Studies on Pensions, Aging and Retirement, is a thinktank and knowledge network. Netspar is dedicated to promoting a wider understanding of the economic and social implications of pensions, aging and retirement in the Netherlands and Europe.

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