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Richer earnings dynamics, consumption and portfolio choice over the life cycle

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  • Gálvez, Julio
  • Paz-Pardo, Gonzalo

Abstract

Households face earnings risk which is non-normal and varies by age and over the income distribution. We show that allowing for these rich features of earnings dynamics, in the context of a structurally estimated life-cycle portfolio choice model, helps to rationalize the limited participation of households in the stock market and their low holdings of risky assets. Because households are subject to more background risk than previously considered, the estimated model implies a substantially lower coefficient of risk aversion. We also find renewed support for rule-of-thumb investment strategies under the model with the nonlinear earnings process. JEL Classification: G11, G12, D14, D91, J24, H06

Suggested Citation

  • Gálvez, Julio & Paz-Pardo, Gonzalo, 2023. "Richer earnings dynamics, consumption and portfolio choice over the life cycle," Working Paper Series 2810, European Central Bank.
    • Handle: RePEc:ecb:ecbwps:20232810
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    More about this item

    Keywords

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    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
    • D14 - Microeconomics - - Household Behavior - - - Household Saving; Personal Finance
    • D91 - Microeconomics - - Micro-Based Behavioral Economics - - - Role and Effects of Psychological, Emotional, Social, and Cognitive Factors on Decision Making
    • J24 - Labor and Demographic Economics - - Demand and Supply of Labor - - - Human Capital; Skills; Occupational Choice; Labor Productivity
    • G5 - Financial Economics - - Household Finance

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