Equilibrium investment under dynamic preference uncertainty

TL;DR

This paper develops a dynamic equilibrium model for portfolio choice where investor preferences evolve stochastically, leading to a new investment demand component that hedges against future preference changes, with insights from numerical analysis.

Contribution

It introduces a novel equilibrium framework for state-dependent preferences driven by stochastic processes, deriving explicit investment policies including a new hedging component.

Findings

Preference dynamics significantly influence investment strategies.

Hedging demand depends on the drift and correlation of preference shocks.

Numerical results show how preference evolution affects risky asset allocation over time.

Abstract

We study a continuous-time portfolio choice problem for an investor whose state-dependent preferences are determined by an exogenous factor that evolves as an It\^o diffusion process. Since risk attitudes at the end of the investment horizon are uncertain, terminal wealth is evaluated under a set of utility functions corresponding to all possible future preference states. These utilities are first converted into certainty equivalents at their respective levels of terminal risk aversion and then (nonlinearly) aggregated over the conditional distribution of future states, yielding an inherently time-inconsistent optimization criterion. We approach this problem by developing a general equilibrium framework for such state-dependent preferences and characterizing subgame-perfect equilibrium investment policies through an extended Hamilton-Jacobi-Bellman system. This system gives rise to a coupled nonlinear partial integro-differential equation for the value functions associated with each state. We then specialize the model to a tractable constant relative risk aversion specification in which the preference factor follows an arithmetic Brownian motion. In this setting, the equilibrium policy admits a semi-explicit representation that decomposes into a standard myopic demand and a novel preference-hedging component that captures incentives to hedge against anticipated changes in risk aversion. Numerical experiments illustrate how features of the preference dynamics -- most notably the drift of the preference process and the correlation between preference shocks and asset returns -- jointly determine the sign and magnitude of the hedging demand and the evolution of the equilibrium risky investment over time.