Optimal consumption and portfolio choice for long-horizon investors

This doctoral thesis proposes a new approach to the problem of optimal consumption and portfolio choice of long-horizon investors facing either time-varying investment opportunities or nontradable labor income. The solution technique replaces the intractable choice problem with an approximate log-linear problem that can be solved analytically using the method of undetermined coefficients.; Chapter 1 addresses the problem when investors have Epstein-Zin utility and face time-varying expected stock returns. When the model is calibrated to US stock market data, it implies that intertemporal hedging motives greatly increase the average demand for stocks by long-lived investors whose risk-aversion coefficients exceed one. The optimal portfolio policy also involves timing the stock market. Failure to time or to hedge can cause large welfare losses relative to the optimal policy.; Chapter 2 analyzes the problem with nontradable labor income and retirement. It shows that non-retired investors should invest in stocks a larger fraction of their savings than retired investors if labor income risk is not positively correlated with stocks. A positive correlation generates a negative hedging demand for stocks. Increasing labor income risk has a positive effect on savings and a negative, relatively smaller effect on portfolio holdings of stocks. The model also explains portfolio choice in the early part of the life-cycle.; Chapter 3 evaluates the conventional wisdom that long-term bonds are appropriate for long-horizon investors who value stability of income, using a model with stochastic interest rates and portfolio constraints. It shows that the demand for long-term bonds has a myopic component that is proportional to the term premium and the reciprocal of relative risk aversion, and an intertemporal hedging component that is proportional to one minus the reciprocal of relative risk aversion. An infinitely risk-averse investor who is infinitely unwilling to substitute consumption intertemporally should hold an indexed bond portfolio that is equivalent to an indexed consol. When nominal bonds are available, the quantity and price of inflation risk also influence optimal bond portfolios.; Finally, Chapter 4 solves the model in Chapter 1 numerically, and finds solutions very similar to the approximate analytical solutions.