Wealth Effect on Portfolio Allocation in Incomplete Markets

Chenxu Li, Olivier Scaillet and Yiwen Shen

Abstract: We develop a novel five-component decomposition of optimal dynamic portfolio choice, which reveals the simultaneous impacts from market incompleteness and wealth-dependent utilities. Under the HARA utility and a nonrandom interest rate, we can explicitly solve for the optimal policy as a combination of a bond holding scheme and the corresponding simpler CRRA strategy. Under a stochastic volatility model estimated on US equity data, we use closed-form solution to demonstrate the sophisticated impacts from the wealth-dependent utilities, including cycle-dependence and hysteresis effect in optimal portfolio allocation, as well as a risk-return trade-off in investment performance.

Date: 2020-04, Revised 2021-08
New Economics Papers: this item is included in nep-cmp
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Persistent link: https://EconPapers.repec.org/RePEc:arx:papers:2004.10096

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