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

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  • Luca Benzoni
  • Pierre Collin-Dufresne
  • Robert S. Goldstein
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    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 {\em 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.

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    Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 11247.

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    Date of creation: Apr 2005
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    Publication status: published as Benzoni, Luca, Pierre Collin-Dufresne and Robert S. Goldstein. "Portfolio Choice over the Life-Cycle when the Stock and Labor Markets Are Cointegrated." The Journal of Finance 62,5 (2007): 2123-2167.
    Handle: RePEc:nbr:nberwo:11247

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    Cited by:
    1. John Y. Campbell & Yves Nosbusch, 2007. "Intergenerational risksharing and equilibrium asset prices," LSE Research Online Documents on Economics, London School of Economics and Political Science, LSE Library 24484, London School of Economics and Political Science, LSE Library.
    2. John Y. Campbell, 2006. "Household Finance," NBER Working Papers 12149, National Bureau of Economic Research, Inc.
    3. Florian Zainhofer, 2007. "Life Cycle Portfolio Choice: A Swiss Perspective," Swiss Journal of Economics and Statistics (SJES), Swiss Society of Economics and Statistics (SSES), Swiss Society of Economics and Statistics (SSES), vol. 143(II), pages 187-238, June.
    4. Charles Ka Yui Leung, 2005. "Equilibrium Correlation of Asset Price and Return," Discussion Papers, Chinese University of Hong Kong, Department of Economics 00017, Chinese University of Hong Kong, Department of Economics.
    5. Alan Gustman & Thomas Steinmeier, 2006. "Financial Risk, Retirement, Saving and Investment," Working Papers, University of Michigan, Michigan Retirement Research Center wp130, University of Michigan, Michigan Retirement Research Center.
    6. Hanno Lustig, 2005. "The Returns on Human Capital: Good News on Wall Street is Bad News on Main Street (joint with Stijn Van Nieuwerburgh)," UCLA Economics Online Papers, UCLA Department of Economics 352, UCLA Department of Economics.
    7. Schmähl, Winfried, 2007. "Soziale Sicherung im Lebenslauf: finanzielle Aspekte in längerfristiger Perspektive am Beispiel der Alterssicherung in Deutschland," Working papers of the ZeS 09/2007, University of Bremen, Centre for Social Policy Research (ZeS).

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