Asset Allocation with Endogenous Labor Income: The Case of Incomplete Markets
59 Pages Posted: 22 Dec 2000
Date Written: December 2000
This paper investigates optimal consumption and portfolio decisions with nontradable labor income and flexible labor supply. This paper considers risky labor income in a setting where wage income and stock returns are not perfectly correlated. The paper provides approximate closed-form solutions to the problem, allowing for a thorough characterization of the optimal consumption and portfolio policies. These solutions show that, when labor income risk is idiosyncratic, the presence of labor/leisure choice can have dramatic positive effects on portfolio allocations relative to the benchmark in which labor income is exogenously given to the investor. The main mechanism delivering this result is that consumption becomes less sensitive to financial downfalls, thus raising the incentive to participate in the stock market.
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