Time-Varying Relative Risk Aversion : Mechanisms and Evidence

This paper explores theoretically and empirically the issue of time-varying relative risk aversion (TVRRA). We analytically solve a parsimonious life-cycle portfolio choice model with the preferences given by Greenwood, Hercowitz and Huffman (1988, GHH). Our analytical solution identifies four partial equilibrium effects of TVRRA generated by GHH preferences on risky shares through two channels, and two general equilibrium effects whose signs hinge on the value of a key structural parameter. Our mean and quantile regression results about how wealth affects portfolio choices are robust and provide strong evidence of TVRRA using micro-data. Thus, we show successfully that TVRRA generated by GHH preferences provides a plausible underlying mechanism in understanding TVRRA in the micro-data. Furthermore, we conclude that such a mechanism alone is not enough in explaining how risky shares respond to labor income and labor income risks in the micro-data