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Federal Reserve Bank of Kansas City
Research Working Paper
Ignorance, Uncertainty, and Strategic Consumption-Portfolio Decisions
Yulei Luo
Jun Nie
Haijun Wang

This paper constructs a recursive utility version of a canonical Merton (1971) model with uninsurable labor income and unknown income growth to study how the interaction between two types of uncertainty due to ignorance affects strategic consumption-portfolio rules and precautionary savings. Specifically, after solving the model explicitly, we theoretically and quantitatively explore (i) how these ignorance-induced uncertainties interact with intertemporal substitution, risk aversion, and the correlation between the equity return and labor income, and (ii) how they jointly affect strategic asset allocation, precautionary savings, and the equilibrium asset returns. Furthermore, we use data to test our model’s predictions on the relationship between ignorance and asset allocation and quantitatively show that the interaction between the two types of uncertainty is the key to explain the data. Finally, we find that the welfare costs of ignorance can be very large.

Download https://doi.org/10.18651/RWP2017-13
Cite this item
Yulei Luo & Jun Nie & Haijun Wang, Ignorance, Uncertainty, and Strategic Consumption-Portfolio Decisions, Federal Reserve Bank of Kansas City, Research Working Paper RWP 17-13, 01 Nov 2017.
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Subject headings:
Keywords: Ignorance; Unknown Income Growth; Induced Uncertainty; Strategic Asset Allocation
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