Time-varying relative risk aversion: Theoretical mechanism and empirical evidence

This paper explores the issue of understanding time-varying relative risk aversion with household-level data on two classical portfolio choice problems. First, we derive an analytic form solution to a parsimonious portfolio choice model with the preference given by Greenwood, Hercowitz and Huffman (1988, GHH), and then, the solution identifies four partial equilibrium effects in our model with the GHH preference on risky shares through two channels and two net effects whose signs hinge on the value of a key structural parameter. Based on household-level data, our empirical results from both mean and quantile regression models show clearly that wealth negatively affects risky shares and the estimated effects are statistically significant and robust, which is in line with the theory. Finally, we show that the GHH preference alone is not sufficient in explaining how risky shares respond to labor income in the household-level data. • A parsimonious portfolio choice model with GHH preferences. • Theoretical results shed light on important questions. • Three empirical regularities are well documented. • Analysis based on quantile regression models is robust. • Our model can characterize how well wealth affects portfolio choices.