Habit persistence reduces risk aversion

How does habit formation affect the dynamic demand for insurance and risky assets? We examine a dynamic portfolio-saving choice problem for two structures of preferences. In the first model, the consumer faces an exogenous path of minimum levels of subsistence over time. In the second model, these l...

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Bibliographic Details
Published inGeneva papers on risk and insurance. Issues and practice Vol. 46; no. 2; pp. 214 - 223
Main Author Gollier, Christian
Format Journal Article
LanguageEnglish
Published London Springer Science + Business Media 01.04.2021
Palgrave Macmillan UK
Palgrave Macmillan
Subjects
Economics and Finance
Finance
Insurance
Risk aversion
Risk Management
Insurance demand
Dynamic portfolio choice
Equity premium
Time diversification
Additive habit
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Summary:How does habit formation affect the dynamic demand for insurance and risky assets? We examine a dynamic portfolio-saving choice problem for two structures of preferences. In the first model, the consumer faces an exogenous path of minimum levels of subsistence over time. In the second model, these levels are subject to habit persistence, i.e. they are increasing in past consumption. We show that adding habit persistence to the initial model substantially reduces the aversion to risk. The intuition is that the positive correlation between current portfolio returns and future levels of subsistence helps time-diversifying risks. This result goes against the wide-spread idea that habit persistence can resolve the equity premium puzzle.
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ISSN:1018-5895
1468-0440
DOI:10.1057/s41288-021-00215-9