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Optimal portfolio choice with asset return predictability and nontradable labor income

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  • Hui-Ju Tsai
  • Yangru Wu

Abstract

We study the optimal consumption and investment choice for long-horizon investors with nontradable labor income and time-varying investment opportunities. Our results suggest that the popular investment recommendation that more conservative investors should hold a higher bond/stock ratio may lack theoretical justification when labor income is considered. When labor income is positively correlated with stock returns, a more risk-averse investor holds a higher bond/stock ratio in her risky portfolio, but the reverse is true when labor income is positively correlated with bond returns. The allocation to stock inherits the inverted U-shaped pattern of labor income growth with respect to expected time until retirement. Investors with lower income growth, namely, younger workers or those near retirement, should invest less in risky assets than those who are in their mid career and have a higher income growth. Performance test shows that the welfare loss of ignoring asset return predictability in the presence of nontradable labor income can be economically significant. Copyright Springer Science+Business Media New York 2015

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  • Hui-Ju Tsai & Yangru Wu, 2015. "Optimal portfolio choice with asset return predictability and nontradable labor income," Review of Quantitative Finance and Accounting, Springer, vol. 45(1), pages 215-249, July.
    • Handle: RePEc:kap:rqfnac:v:45:y:2015:i:1:p:215-249
    DOI: 10.1007/s11156-014-0435-7
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    More about this item

    Keywords

    Portfolio choice; Return predictability; Nontradable labor income; Life cycle; G11; G12;
    All these keywords.

    JEL classification:

    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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