Life-Cycle Risk-Taking with Personal Disaster Risk

Abstract

Inspired by a growing body of empirical work, this paper models a non-linear labor income process allowing for a personal disaster, such as long-term unemployment or disability, during working years. Such a disaster entails an uncertain but potentially large permanent shock to earnings. Personal disaster risk allows to match moderate risk-taking of young investors and a flat investment profile in age, observed in the United States, when the calibration of both the disaster probability and the expected permanent loss in the disaster state is conservative.

Keywords: Life-cycle portfolio choice, disaster risk, beta distribution, non-linear income process, unemployment risk, disability risk