Portfolio Choice Over the Life-Cycle in the Presence of 'Trickle Down' Labor Income

51 Pages Posted: 23 Jan 2005

See all articles by Luca Benzoni

Luca Benzoni

Federal Reserve Bank of Chicago - Research Department

Pierre Collin-Dufresne

Ecole Polytechnique Fédérale de Lausanne; Swiss Finance Institute; National Bureau of Economic Research (NBER)

Robert S. Goldstein

University of Minnesota - Twin Cities - Carlson School of Management; National Bureau of Economic Research (NBER)

Multiple version iconThere are 2 versions of this paper

Date Written: 12/31/04

Abstract

Empirical evidence shows that changes in aggregate labor income and stock market returns exhibit only weak correlation at short horizons. As we document below, however, this correlation increases substantially at longer horizons, which provides at least suggestive evidence that stock returns and labor income are cointegrated. In this paper, we investigate the implications of such a cointegrated relation for life-cycle optimal portfolio and consumption decisions of an agent whose non-tradable labor income faces permanent and temporary idiosyncratic shocks. We find that, under economically plausible calibrations, the optimal portfolio choice for the young investor is to take a substantial short position in the risky portfolio, in spite of the large risk premium associated with it. Intuitively, this occurs because the cointegration effect makes the present value of future labor income flows 'stock-like' for the young agent. However, for older agents who have shorter times-to-retirement, the cointegration effect does not have sufficient time to act, and the remaining human capital becomes more 'bond-like.' Together, these effects create a hump-shaped optimal portfolio decision for the agent over the life cycle, consistent with empirical observation.

Keywords: Labor Income Risk, Optimal Portfolio Choice, Limited Stock Market Participation, Human Capital

JEL Classification: G11

Suggested Citation

Benzoni, Luca and Collin-Dufresne, Pierre and Goldstein, Robert S., Portfolio Choice Over the Life-Cycle in the Presence of 'Trickle Down' Labor Income (12/31/04). Available at SSRN: https://ssrn.com/abstract=651061 or http://dx.doi.org/10.2139/ssrn.651061

Luca Benzoni (Contact Author)

Federal Reserve Bank of Chicago - Research Department ( email )

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Pierre Collin-Dufresne

Ecole Polytechnique Fédérale de Lausanne ( email )

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Robert S. Goldstein

University of Minnesota - Twin Cities - Carlson School of Management ( email )

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National Bureau of Economic Research (NBER)

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