Time Variation in Life Expectancy, Optimal Portfolio Choice and the Cross-Section of Asset Returns
44 Pages Posted: 26 Jan 2010 Last revised: 30 Dec 2015
Date Written: December 1, 2015
I solve a portfolio optimization problem with stochastic death rates. An agent demands more of an asset that pays off high (low) in states of the world when he expects to live longer (shorter) than an asset with the opposite payoff. Consequently, in equilibrium, an asset with a positive correlation between its returns and changes in the life expectancy pays a lower expected return than an asset with a negative correlation. Empirical evidence supports the model. Out-of-sample evidence suggests that a trading strategy, which exploits the theoretical relationship, pays 3.25% annual unexplained returns according to the CAPM.
Keywords: uncertain life expectancy, uncertain lifetime, portfolio optimization under uncertainty, time variation in life expectancy, stochastically changing mortality rates, demographic change, intertemporal consumption choice, annuity, life cycle consumption, capital asset pricing, cross-section of returns
JEL Classification: G11, G12, D91
Suggested Citation: Suggested Citation