Mass Customization in Life-Cycle Investing Strategies with Income Risk

Formal intertemporal portfolio selection models show that the utility maximizing strategy for an individual investor depends on a number of subjective characteristics such as the investor’s horizon, risk aversion and non-financial income, in addition to depending on market conditions. These insights are vastly ignored by current forms of target date fund products, which most often propose a deterministic decrease in the equity allocation regardless of market conditions, and ignore the question of labor income risk. This paper shows that, in spite of a high degree of heterogeneity in individual investors’ income streams, grouping investors with similar income profiles, and implementing a unique investment strategy for all members of a given class, involves only a limited welfare cost with respect to an idealized fully customized strategy. Our results also suggest that these strategies consistent with mass-customization constraints strongly dominate allocation strategies that completely ignore the presence of income risk.