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LIFETIME PORTFOLIO SELECTION UNDER
UNCERTAINTY: THE CONTINUOUS-TIME CASE
Robert C. Merton *
t C(s),w(s) } (18)
+ I [W (t),t] I ( 14') and
If t = to + h and the third partial derivatives (kw[w*;C*;W;t] - 0 = (a-r) DW
of I[W(to),to] are bounded, then by Taylor's
theorem and the mean value theorem for in-
+ WWr2. (19)
tegrals, (16) can be rewritten as
I[W(to,to] = Max E(to) {
ePtU[C(t)] A set of sufficient conditions for a regular in-
{C,w} DI[W(t0),t0] terior maximum is
+ I[W(to),to] + at
4ww < 0; oce < 0; det[ ww OweJ > 0.
iOew O ea
+ aI[W(to),to] [W(t) - W(to]
Owe = ?tw = 0, and if I[W(t),t] were strictly
1 D2I[W(to),;t] concave in W, then
2 DW2 = U"(c) < 0, by the strictconcavityof U
[W(t) - W(to)]2 + O(h2) } and
(20)
where t-E [to,t]. (17)
2 The basic derivation of the optimality equations in this 30(w,C:W:t) is short for the rigorouso[w,C; 3It/3t;
section follows that of S. E. Dreyfus [2], Chapter VII. aIt/DW; alItlaW'; It: W;t].-
250 THE REVIEW OF ECONOMICS AND STATISTICS
32t where a strategically-simplifying assumption
ou7 = W(t)of2 by the strict con- has been made as to the particular
< 04,
DW2 form of the
cavityof It, (21) bequest valuation function, B[W(T),T].5
and the sufficientconditions would be satisfied. To solve (17") of (*'), take as a trial solu-
Thus a candidate for an optimal solution which tion,
causes I[W(t),t] to be strictly concave will be t[W(t),t] = ()e_pt [W(t)],Y (22)
any solution of the conditions (17')-(21).
The optimality conditions can be re-written By substitution of the trial solution into (17"),
as a set of two algebraic and one partial dif- a necessary condition that It [W(t) ,t] be a
ferential equation to be solved for w* (t), C* (t), solution to (17") is found to be that b(t) must
and I[W(t),t]. satisfy the following ordinary differentialequa-
cf[w*;C*;W;t] = 0 (18") tion,
Fa [[w*C*; W;t] = 0
OW[W*,C*;W;t] = 0
(18)
(19)
b(t) = ph(t)-(1-y) [b(t)]-'Y1/-Y (23)
subject to b(T) = E1l-, and where p,u p - y
(*) subjectto the boundarycondition
[(a - r)2/2cr2 (1 -_y) + r]. The resulting de-
I[W(T),T] = B[W(T),T] and
the solutionbeing a feasiblesolu- cision rules for consumptionand portfolio selec-
tion to (14). tion, C* (t) and w* (t), are from equations
(18) and (19) of (*'), then
IV ConstantRelativeRiskAversion C*(t) = [b(t)]1'Y-' W(t) (24)
and
The system (*) of a nonlinear partial dif-
ferential equation coupled with two algebraic w*(t) = (a-r) (25)
equations is difficult to solve in general. How- 2) (25)
The solution to (23) is
ever, if the utility function is assumed to be of
b (t) = { [ 1 + (vE-1) e(t-T) ] /v}l-y (26)
the form yielding constant relative risk-aver-
sion (i.e., iso-elastic marginal utility), then (*) where v ,/( 1 - y).
can be solved explicitly. Therefore, let U(C) A sufficient condition for I[W(t),t] to be a
= C/y, yy< 1 and y70 or U(C) =log C solution to (*') is that I[W(t),t] satisfy
(the limiting form for y = 0) where- U" (C) A. I [W(t),t] be real (feasibility)
C/U'(C) = 1- 8 is Pratt's [7] measure
of relative risk aversion. Then, system (*) can B. 32t (concavity for a maxi-
a W2 mum)
be written in this particular case as C. C*(t) 0 (feasibility)
The condition that A, B, and C are satisfied in
7 the iso-elastic case is that
DIt DIt > 0, 0 - t - T (27)
+ t + @W rW [1 + (vE-l) ev(t-T)]/V
D3t DaW which is satisfied for all values of v when
(a-r) 2 [3It/fW] 2 (l 7ff) T < oo.
(*') - 2r2 32It/DW2
3 Because (27) holds, the optimal consump-
C*(t) ept (18)
= tion and portfolio selection rules are,6
'The form of the bequest valuation function (the bound-
= (a-r) Dlt/DW (19) ary condition), as is usual for partial differential equations,
w*(t) can cause major changes in the solution to (*). The par-
92W D2It/D3W2 ticular form of the function chosen in (*') is used as a
subject to I[W(T),T] = El-ye-pT proxy for the "no-bequest" condition (e = 0). A slightly
more general form which can be used without altering the
[W(T)]Y/y,forO <e << 1 resulting solution substantively is B[W(T),T] = e-PtG(T)
By the substitution of the results of (18) into (19) at [W(T)] 'Y/y for arbitrary G(T). If B is not of the iso-
(C*,w*), we have the condition w*(t) (a- r) > 0 if and elastic family, systematic effects of age will appear in the
32It optimal decision-making.
32
only if < 0. 'Although not derived explicitly here, the special case
The paper considers only interior optimal solutions. The (y = 0) of Bernoulli logarithmic utility has (29) with y = 0
problem could have been formulated in the more general as a solution, and the limiting form of (28), namely
Kuhn-Tucker form in which case the equalities of (18) and C*(t) = + p ' W(t).
(19) would be replaced with inequalities. I+ (pe-1I) ep(t-T)
LIFETIME PORTFOLIO SELECTION 251
C*(t) = [v/(1 + (vE-1) ep(t-T))] W(t), To examine some of the dynamic properties
for v 0 of C*(t), let E= 0, and define V(t) = [C*(t)/
= [1/(T -t + e)] W(t), for v = 0 W(t)], the instantaneous marginal (in this
(28) case, also average) propensity to consume out
and of wealth. Then, from (28),
w*(t) - ((I) = a constant independ-
V(t) = [V(t)]2 ev(t-T) (30)
ent of W or t. (29) and, as observed in figure 1 (for E= 0), V(t)
is an increasing function of time. In a generali-
V DynamicBehaviorand the Bequest zation of the half-life calculation of radioactive
ValuationFunction decay, define X as that tE [0,T] such that V(X-)
The purpose behind the choice of the par- = nV(O) (i.e., X is the length of time required
ticular bequest valuation function in (*') was for V(t) to grow to n times its initial size).
primarily mathematical. The economic motive Then, from (28),
is that the "true" function for no bequests is
Tlog[ eT (1 ) + ] /v; for v 0
B[W(T),T] = 0 (i.e., E= 0). From (28),
C*(t) will have a pole at t = T when E = 0.
So, to examine the dynamic behavior of C*(t) - ( ( )) T , for v =0.
(n)
and to determine whether the pole is a mathe- (31)
matical "error" or an implicit part of the eco-
To examine the dynamic behavior of W(t)
nomic requirementsof the problem, the param-
under the optimal decision rules, it only makes
eter E was introduced.
sense to discuss the expected or "averaged"
From figure 1, (C*/W)t=T -> oo asE--> 0. How-
behavior because W(t) is a function of a ran-
ever, one must not interpret this as an infinite
dom variable. To do this, we consider equation
FIGURE 1.
(13), the averaged budget equation, and evalu-
Ge/w ate it at the optimal (w*,C*) to form
0
M
'V I W( = V- V(t) (13')
w (t)
whereatr).= [ (a-
~2(1 +r], and, in sec-
+ it [ (w(t) (a-r) + r)W(t) - C(t)] which is a condition for convergence of the in-
tegral in (14). A solution to (14) must satisfy
t (39) plus conditions A, B, and C of section IV.
+ 1/2 2w2(t)W2(t) (17')
Conditions A, B, and C will be satisfied in the
However (17') can be greatly simplified by iso-elastic case if
eliminating its explicit time-dependence. De-
fine V* V P (a[ -
r)2 + r ]
1--y 2or2(1_y)2 1-y
J [W (t) t] ePt I [W(t) t] >0 (40)
=Max E(t) fooe-P(sYt) U[C]ds holds where (40) is the limit of condition (27)
{C,w}
in section IV, as T -> oo and V* = C*(t)/W(t)
= Max EfO e-Pv U[C]dv,
when T = oo. Condition (39) will hold if p >
0 0
{C,w}
independent of explicit time. (34) y W/W where, as defined in (13), W(t) is the
Thus, write J[W(t),t] = J[W] to reflect this stochastic time derivative of W(t) and W(t)/
independence. Substituting J[W], dividing by W(t) is the "expected" net growth of wealth
e-Pt, and dropping all t subscripts, we can re- after allowing for consumption. That (39) is
write (17') as, satisfied can be rewritten as a condition on the
O = Max [U(C)-pi + J'(W). subjective rate of time preference,p, as follows:
{C,w} for y < 0 (boundedutility), p> 0
+ r)W-C} = 0 (Bernoulli log case), p> 0
{(w(t)(a-r)
+ 1/2 1"(W)aU2w2W2]. (35) 0 < y < 1 (unboundedutility), p> y
Note: when (35) is evaluated at the optimum
[ (a-r)2(2- y) + r
(C*,w*), it becomes an ordinary differential 2L 2 ( 1) _j.
equation instead of the usual partial differential (41)
equation of (17'). For the iso-elastic case, Condition (41) is a generalization of the usual
(35) can be written as assumption required in deterministic optimal
consumption growth models when the produc-
8"Hump saving" has been widely discussed in the litera- tion function is linear: namely, that p > Max
ture. (See J. De V. Graaff [3] for such a discussion.)
Usually "hump saving" is discussed in the context of work [0, y ,8] where /3 = yield on capital.9 If a "di-
and retirement periods. Clearly, such a phenomenon can
occur without these assumptions as the example in this 'If one takes the limit as o-*2 0 (where a.2 is the
paper shows. variance of the composite portfolio) of condition (41), then
LIFETIME PORTFOLIO SELECTION 253
minishing-returns," strictly-concave "produc- generates the price changes (independent in-
tion" function for wealth were introduced, then crements assumption of the Wiener process).
a positive p would suffice. With these two assumptions, the only feed-
If condition (41) is satisfied, then condition backs of the system, the price change and the
(40) is satisfied. Therefore, if it is assumed resulting level of wealth, have zero relevance
that p satisfies (41), then the rest of the deri- for the portfolio decision and hence, it is con-
vation is the same as for the finite horizon case stant.
and the optimal decision rules are, The optimal proportion in the risky asset,10
w*, can be rewritten in terms of Pratt's relative
C,X*(t) =__
Cx*(t) { p_
-
7Y [ 22(a-r)2
2o2( risk-aversion measure, 8, as
t+z* = + -
t vo1) - 2 (t)z
[C* C*2a I (52)
= Wo >
V W(t)
= (46) Therefore, by combining the effects of (51)
where V = the marginal propensity to consume and (52), one can see that individuals with low
out of wealth. relative risk-aversion (O < 8 < 1) will choose
The tools of comparative statics are used to to consume less now and save more to take ad-
examine the effect of shifts in the mean and vantage of the higher yield available (i.e., the
variance on consumptionbehavior in this mod- substitution effect dominatesthe income effect).
el. The comparison is between two economies For high risk-averters (8 > 1), the reverse is
with different investment opportunities, but true and the income effect dominates the sub-
with the individuals in both economies having stitution effect. In the borderline case of Ber-
the same utility function. noulli logarithmic utility (8 = 1), the income
If 0 is a financial parameter, then define and substitution effect just offset one another.'2
[ DC ] the partial derivative of consump-
In a similar fashion, consider the case of
0 = - T*2213 then from, (46) and (48), we de-
tion with respect to 0, IO[WO]being held fixed, rive
as the intertemporal generalization of the
effect,[ a
Hicks-Slutsky"substitution" ]U ( ( -2) ) = W2V (53)
DO U and
for static models. [DC*/DO- (DC*/DO)1O]
will be defined as the intertemporal "income" ( )) = 2 < , the substitution
or "wealth" effect. Then, from equation (22) effect. (54)
with Io held fixed, one derives by total differen- Further, DC*/D(-Go*2) =
(8-1)WO/2, and so
tiation, D DC* C* A
=-^1
0 Db(f Wo + b(O) (DW o J- 3(-(r2 ) 3( r2
* ) 10
-8-1
)
DO Do'1
(47)
= 2 WO > O, the incomeeffect.
From equations (24) and (46), b(O) = V-1,
in (47), we can
and so solving for (DWO/DO)1O (55)
write it as To compare the relative effect on consump-
tion behavior of an upward shift in the mean
awO -swo av
(48)
versus a downward shift in variance, we ex-
Do Io (8-1)V 30
amine the elasticities. Define the elasticity of
Consider the case where O= a*, then from consumption with respect to the mean as
(46), DC*
aV (8-1) Elct - /C* a*( -1)/8V (56)
_
(9) Da*
Da* 8
and similarly, the elasticity of consumption
and from (48), with respect to the variance as,
(DC* wo (50)
E2 D2aC* / C*= _2(8_ 1)/2V (57)
Da Io V
Thus, we can derive the substitution effect of For graphical simplicity, we plot el
an increase in the mean of the composite port- [VE,/a*] and e2 - -[VE2/a*] and define k
folio as follows,
( I D
[DV W ]Io
'2Many writers have independently discovered that Ber-
noulli utility is a borderline case in various comparative-
Da* Ii0 LDac Dat* i0 static situations. See, for example, Phelps [6] and Arrow
w0 [1].
[1 Because increased variance for a fixed mean usually
=- < 0. (51)
-
(always for normal variates) decreases the desirability of
investment for the risk-averter, it provides a more sym-
Because DC*/Da* = (V/Da*))Wo= [(8-1)/8] metric discussion to consider the effect of a decrease in
Wo, then the income or wealth effect is variance.
LIFETIME PORTFOLIO SELECTION 255
FIGuRE 2. higher future consumption while the high risk
ei
I - -- --- - -- ------ -
averter will always choose to increase the
amount of present consumption.
high risk averter (8 > 1) will always increase equations (6) and (7) can be written as,
present consumption more with a decrease in E(to) [W(t) -W(to)]
variance than for the same percentage increase = [w' (to) (a-r) + r] W(to) k
in mean. Because a high risk-averter prefers -C(to)k + 0(h2) (6)
a steadier flow of consumption at a lower level and
than a more erratic flow at a higher level, it E(to) [(W(t) -W(to) )2
makes sense that a decrease in variance would = w'(to) a w(to) W2(to)h
have a greater effect than an increase in mean. + 0(h2) (7)
On the other hand, for relatively low variance where
(k < 1), a low risk averter (0 < 8 < 1) will w'(to) [wi(to), .... ,wn(to)], a n-vector
always decrease his present consumption more at - a,, ... 1 a<]
with an increase in the mean than for the same = [r,...,r] a n-vector
percentage decrease in variance because such Q [fj[], the n X n variance-covariance
an individual (although a risk-averter) will matrixof the risky assets
prefer to accept a more erratic flow of con- a is symmetricand positivedefinite.
sumption in return for a higher level of con- Then, the general form of (35) for m-assets is,
sumption. Of course, these qualitative results in matrix notation,
will vary depending upon the size of k. If the O=Max [U(C)-p J(W)
riskiness of the returns is very small (i.e., {C,w}
k < < 1), then the high risk-averter will in- + J'(W) { [w'(a-r) + r] W - C}
crease his present consumption more with an
upward shift in mean. Similarly, if the risk- + 2 J"(W) weQ wW2] (58)
level is very high (i.e., k > > 1) the low risk and instead of two, there will be m first-order
averter will change his consumptionmore with conditions correspondingto a maximization of
decreases in variance. (35) with respect to w, .. . , wn, and C. The
The results of this analysis can be summed optimal decision rules corresponding to (42)
up as follows: Because all individuals in this and (43) in the two-asset case, are
model are risk-averters, when risk is a domi- A A