Habit Formation from Correlation Aversion

Authors:
Kenneth C. Lichtendahl;Raul O. Chao;Samuel E. Bodily
Affiliations:
Darden School of Business, University of Virginia, Charlottesville, Virginia 22903;Darden School of Business, University of Virginia, Charlottesville, Virginia 22903;Darden School of Business, University of Virginia, Charlottesville, Virginia 22903
Venue:
Operations Research
Year:
2012

Citing 12
Cited 1

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Abstract

Making plans about how much to consume and how much to invest in risky assets over an uncertain lifetime is a fundamental economic challenge. The leading models of this planning problem use either additive or habit-forming preferences. For the most part, these models assume an individual is either correlation neutral or correlation seeking in consumption, respectively. In this paper, we introduce two habit-forming, correlation-averse preference models. With these preferences, we find closed-form solutions to the classic consumption and portfolio planning problem. Our solutions recommend that a correlation-averse decision maker follow a habit in their consumption plans. While such habits traditionally have been associated with correlation-seeking preferences, our model leads to consumption habits from correlation-averse preferences.