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Occupation-Level Income Shocks and Asset Returns: Their Covariance and Implications for Portfolio Choice

71 Pages Posted: 26 Oct 2000  

Steven J. Davis

University of Chicago; National Bureau of Economic Research (NBER)

Paul Willen

Federal Reserve Bank of Boston - Research Department; National Bureau of Economic Research (NBER)

Multiple version iconThere are 2 versions of this paper

Date Written: August 2000

Abstract

This paper develops and applies a simple graphical approach to portfolio selection that accounts for covariance between asset returns and an investor's labor income. Our graphical approach easily handles income shocks that are partly hedgable, multiple risky assets, many periods and life cycle considerations.

We apply the approach to occupation-level components of individual income innovations estimated from repeated cross sections of the Current Population Survey. We characterize several properties of these innovations, including their covariance with aggregate equity returns, long-term bond returns and returns on several other assets. Aggregate equity returns are uncorrelated with the occupation-level income innovations, but a portfolio formed on firm size is significantly correlated with income innovations for several occupations, and so are selected industry-level equity portfolios.

An application of the theory to the empirical results shows (a) large predicted levels of risky asset holdings compared to observed levels, (b) considerable variation in optimal portfolio allocations over the life cycle, and (c) large departures from the two-fund separation principle.

JEL Classification: G11, D91, D52, J30

Suggested Citation

Davis, Steven J. and Willen, Paul, Occupation-Level Income Shocks and Asset Returns: Their Covariance and Implications for Portfolio Choice (August 2000). CRSP Working Paper No. 523. Available at SSRN: https://ssrn.com/abstract=241161 or http://dx.doi.org/10.2139/ssrn.241161

Steven J. Davis (Contact Author)

University of Chicago ( email )

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National Bureau of Economic Research (NBER)

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Paul S. Willen

Federal Reserve Bank of Boston - Research Department ( email )

600 Atlantic Avenue
Boston, MA 02210
United States

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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