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Long-run Consumption Risk and Asset Allocation under Recursive Utility and Rational Inattention

Luo, Yulei and Young, Eric (2013): Long-run Consumption Risk and Asset Allocation under Recursive Utility and Rational Inattention.

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Abstract

We study the portfolio decision of a household with limited information-processing capacity (rational inattention or RI) in a setting with recursive utility. We find that rational inattention combined with a preference for early resolution of uncertainty could lead to a significant drop in the share of portfolios held in risky assets, even when the departure from standard expected utility with rational expectations is small. In addition, we show that the equilibrium equity premium increases with the degree of inattention because inattentive investors with recursive utility face greater long-run risk and thus require higher compensation in equilibrium. Our results are robust to the presence of correlation between the equity return and the RI-induced noise and the presence of non-tradable labor income.

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