Asset smoothing, consumption smoothing and the reproduction of inequality under risk and subsistence constraints

A growing literature asks whether low-wealth agents can accumulate assets over time or whether they are trapped in poverty. This paper develops a stochastic dynamic programming model with endogenous asset price risk to explore savings and portfolio decisions in a resource-poor environment characterized by risk and subsistence constraints. Optimal portfolio strategies are found to bifurcate, despite divisible assets and fully rational agents. Wealthier agents acquire a higher-yielding portfolio and pursue conventional consumption smoothing. Poorer agents acquire a less remunerative portfolio and pursue asset smoothing, rather than consumption smoothing. Asset-based risk coping thus results in positive correlation between initial wealth and portfolio rate of return. (C) 2003 Elsevier Science B.V. All rights reserved.