Essays in consumption and portfolio choice

This thesis analyzes optimal consumption and portfolio strategy by considering three different extensions to the classic work by Merton (1971). The first chapter considers consumption and strategic asset allocation when expected returns are predictable for Epstein-Zin preferences. The second chapter focuses on the role of imperfect information in the consumption and portfolio choice problem and presents a tractable solution to the strategic asset allocation problem in incomplete markets. The third chapter considers the role of human capital in consumption and portfolio choice and presents normative evidence of hump-shaped life-cycle investment in risky assets, in line with empirical findings on asset allocation strategies. In Chapter 1 (co-authored with John Campbell, George Chacko, and Luis Viceira) we derive an approximate solution to a continuous-time intertemporal portfolio and consumption choice problem. The problem is the continuous-time equivalent of the discrete-time problem studied by Campbell and Viceira (1999), in which the expected excess return on a risky asset follows an AR(1) process, while the riskless interest rate is constant. We show also how to obtain continuous-time parameters that are consistent with discrete-time econometric estimates. The continuous-time solution is numerically close to that of Campbell and Viceira and has the property that conservative long-term investors have a large positive intertemporal hedging demand for stocks. In Chapter 2, we relax the assumption on preferences made in Chapter 1 and consider how imperfect information about expected excess returns on the risky asset shifts the asset allocation strategy. I present a model of consumption and portfolio choice with imperfect information.