Income Risk and Portfolio Choice: An Empirical Study

Abstract

This paper investigates the relationship between portfolio choice and labor income risk in the National Longitudinal Survey of Youth 1979 Cohort. Permanent income risk (variability of shocks to income that have permanent effect) significantly reduces the share of risky assets in the household's portfolio, while transitory income risk (variability of shocks with no lasting effect) does not. This result provides strong evidence that households' portfolio choices respond to labor income risks in a manner consistent with economic theory. Copyright (c) 2009 the American Finance Association.

Labor-Market Uncertainty and Portfolio Choice Puzzles

“…We find that a household whose head is working in an industry where the labor-income volatility is 10% larger than the mean makes safer financial investments, exhibiting a risky share 2.2% lower than the average. This is consistent with Angerer and Lam (2009), who find a negative correlation between labor-income risk and risky share of workers among the NLSY 1979 cohort.…”

“…As the risk in the labor market (the variance of the labor-income shock) increases by 1%, the household's risky share decreases by 0.22 percentage point (with a standard error of 0.06). This is consistent with Angerer and Lam (2009), who find a negative correlation between labor-income risks and the share of risky assets from the NLSY 1979 cohort. The other coefficients are consistent with our economic priors.…”

International diversification and industry-related labor income risk

“…1 Our …ndings also provide insights on whether occupational pension funds may di¤erentiate their investment strategies from those of open-end pension funds. 2 Members in any given occupational plan plausibly face the same industry shocks, since membership is based on their employment industry. On the contrary, participants in open-end pension fund belong to di¤erent industries.…”

International Diversification and Labor Income Risk

“…Baxter and Jermann (1997) …nd a quasi-perfect positive correlation among domestic returns to human and physical capital, which should induce a short position in domestic assetswidening the home bias. 2 On the contrary, Bottazzi et al (1996), while con…rming that human capital and physical capital returns have positive correlation, argue that accounting for human capital reduces the bias towards domestic assets. Indeed, they …nd a negative correlation with …nancial returns, which reduces the home bias by about 30%.…”