Stock Market Mean Reversion and Portfolio Choice over the Life Cycle

Abstract

We solve for optimal consumption and portfolio choice in a life-cycle model with short-sales and borrowing constraints; undiversifiable labor income risk; and a predictable, time-varying, equity premium and show that the investor pursues aggressive market timing strategies. Importantly, in the presence of stock market predictability, the model suggests that the conventional financial advice of reducing stock market exposure as retirement approaches is correct on average, but ignoring changing market information can lead to substantial welfare losses. Therefore, enhanced target-date funds (ETDFs) that condition on expected equity premia increase welfare relative to target-date funds (TDFs). Out-of-sample analysis supports these conclusions.