Health and Portfolio Choice in Retirement: The Impact of Ambiguity∗

This paper first documents that in the U.S., the stock market participation rate over the life-cycle decreases as people age. This fact, however, can not be captured by standard model where smooth expected utility function predicts the decision maker stay in the stock market, given positive equity premium and independence between older people’s non-asset income and stock return. This paper successfully replicates this fact by introducing Knightian uncertainty into a dynamic model with choices on medical care and consumption, as well as saving and portfolio. We assume the agents in the model have ambiguity towards the correlations between risky stock return and risky medical price inflation. In this environment, retirees quit the stock market under reasonable range of ambiguity towards the correlation. The key mechanism is that: The agents do not hold positive amount of stocks since they worry stocks co-vary positively with the non-asset income minus the health expenses. Similarly, they do not short stocks as they also worry that stocks and their de facto non-asset income may co-move negatively. ∗Guo is grateful to his advisor Narayana Kocherlakota for his guidance and encouragements. Guo is very thankful to Kim Sau Chung, Roger Feldman, Fatih Guvenen, Katya Kartashova, Chris Phelan, and Martin Schneider for for many fruitful conversations. Guo is also grateful to Greg Kaplan, Karen Kopecky, Minjung Park, and Fabrizio Perri for helpful suggestions. He thanks seminar participants at University of Hawaii. Both Guo and He thank Zheng Liu for his contribution in the early stage of this paper. All errors are the sole responsibility of the authors. †Address: Department of Economics, 4-101 Hanson Hall, 1925 Fourth Street South, Minneapolis, MN 55455. Email: [email protected]; ‡Address: Department of Economics, 2424 Maile Way, Saunders Hall Room 528, Honolulu, HI 96822. Email: [email protected];