How Much Should Life-Cycle Investors Adapt their Behavior when Confronted with Model Uncertainty?

Abstract

I investigate a dynamic life-cycle strategic asset allocation and consumption problem under model uncertainty, where both inflation rate and income growth rate are assumed to be estimated with errors. I present a feasible boundary for the uncertainty aversion parameter, which measures the investor's preference for robustness using econometric theory. I derive a closed-form solution for a robust investor characterized by min-max utility preference to insure against the worst case scenario. Robustness dramatically increases the demand for the long-term bonds when the instantaneous inflation rate is low.