Consumption-Income Sensitivity and Portfolio Choice
72 Pages Posted: 16 Mar 2014 Last revised: 18 Jun 2018
Date Written: April 30, 2018
Contrary to the predictions of traditional life-cycle models, household consumption is excessively sensitive to current income. Similarly, weak evidence of income hedging runs against standard portfolio theory. We link these two puzzles by modifying the theoretical framework of Viceira (2001) to study how consumption-income sensitivities generated by income in the utility function impact household portfolio choice. Empirically, we find that consumption-income sensitivities affect asset allocation through the income hedging motive. In particular, we show that the interaction between consumption-income sensitivity and the correlation of income growth to stock market returns is an important explanatory variable for households' stock market holdings.
Keywords: life-cycle consumption, income hedging, portfolio theory, consumption-income sensitivity
JEL Classification: D11, D12, D14, G11
Suggested Citation: Suggested Citation