Optimal Decision Making under Time Diversification

One of the most enduring questions in finance is the persistence of investment risk across time. Traditional finance lacks of recipes on how to approach and how to hedge non-diversifiable risks. Risks that can not be diversified at a given point in time can nevertheless be averaged over time thereby reducing their impact on individual welfare. One hedging strategy for non-diversifiable risks is intergenerational risk sharing. The present paper is based on the general equilibrium model of Allen and Gale (1997). We extend their model in various directions: The intermediary is a firm and not a planner, the financial market is assumed to be incomplete and the mechanism of intergenerational risk sharing is endogenously determined. Our model allows for the analysis of optimal behavior of individuals and of the intermediary together with the respective feed-back processes. Finally we are able to compare voluntary versus compulsory membership in pension funds and to present a rationale for the existence of security funds (funds of funds).