The Power of Human Capital in Lifecycles. Insights from a Flexible Framework

Abstract

This paper develops a novel and flexible life-cycle framework, where borrowing human capital plays an explicit role in modeling and decision-making, explicitly impacting risk-aversion levels, borrowing rates, and inter-temporal discount rates. We solve this new ``double'' optimization problem in semi-closed form in a region of the control/policy space while developing a numerical procedure to approximate the remaining region using the solvable cases. We carry out numerical case studies revealing two unprecedented conclusions. First, the optimal level of human capital borrowings depends non-trivially on many characteristics of the investor and the market, e.g., range of borrowing cost and risk aversion, subjective discount rate, future income level, and size of their initial endowment. Second, we observe a high level of welfare losses when investors fail to take advantage of their human capital; for instance, investors with high endowment could experience a welfare loss exceeding 70%, while investors with high income could see a 20% welfare loss.

Keywords: Utility maximization, Human capital modelling, Investor's life cycle, Borrowing costs, Welfare loss