Optimal Life-Cycle Portfolios for Heterogeneous Workers*

Abstract

Abstract. Household portfolios include risky bonds, beyond stocks, and respond to permanent labour income shocks. This paper brings these features into a life-cycle setting, and shows that optimal stock investment is constant or increasing in age before retirement for realistic parameter combinations. The driver of such inversion in the life-cycle profile is the resolution of uncertainty regarding social security pension, which increases the investor's risk appetite. This occurs if a small positive contemporaneous correlation between permanent labour income shocks and stock returns is matched by a realistically high degree of risk aversion. Absent this combination, the typical downward sloping profile obtains. Overlooking differences in optimal investment profiles across heterogeneous workers results in large welfare losses, in the order of 15-30% of lifetime consumption.

Life-cycle risk-taking with personal disaster risk

“…3 We set to zero all the coefficients that are not statistically significant from zero at the 5% level. 4 Such patterns are also robust across education levels (unreported here).…”

“…Our results highlight the role of non-linear income shocks in flattening the age profile of risk taking. With a linear income process, prior models resort to using additional features to explain reduced risk-taking in financial markets (Cocco, 2004 Bagliano, Fugazza and Nicodano (2014), a positive correlation between (highly volatile) permanent income shocks and stock returns leads to lower optimal risk-taking when young. Branger, Larsen and Munk (2019) obtain reduced early-life holdings by introducing unemployment risk correlated with business cycle fluctuations.…”

“…This model does not address non-participation in the stock market. It should otherwise allow for correlation between stock returns and labor income shocks (see Bagliano, Fugazza and Nicodano (2014) for additional conditions and Bonaparte, Korniotis and Kumar (2014) for empirical results) or correlation between stock returns and the skewness of labor income shocks (Catherine, Sodini and Zhang, 2020). Likewise, prominent papers study consumption and labor market choices with permanent income shocks (Low, Meghir and Pistaferri, 2010;Low and Pistaferri, 2015), focusing on the design of social insurance against employment and productivity risk without allowing for investments in risky assets.…”