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Life Cycle Uncertainty and Portfolio Choice Puzzles

  • Yongsung Chang

    (University of Rochester / Yonsei Univ.)

  • Jay Hong

    (University of Rochester)

  • Marios Karabarbounis

    (Federal Reserve Bank of Richmond)

The standard theory of household portfolio choice is hard to reconcile with the following facts. (i) Despite a high rate of returns the average household holds a low share of risky assets (equity premium puzzle). (ii) The share of risky assets increases in age. (iii) The share of risky assets is disproportionately larger for richer households. We show that a simple life-cycle model with learning about earnings ability can successfully address all three puzzles. Young workers, on average asset poor, face larger uncertainty in their life-time labor income because they do have perfect knowledge of their ability in the market. They hedge this risk in human capital by investing in relatively safe financial assets. As earnings ability is gradually revealed over time, they take more risk in financial investment. When the labor income risks are calibrated to those observed in the Panel Study of Income Dynamics, our model with learning reproduces the investment profile we see in the Survey of Consumer Finances.

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Paper provided by Society for Economic Dynamics in its series 2013 Meeting Papers with number 595.

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Date of creation: 2013
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Handle: RePEc:red:sed013:595
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  1. Steven J. Davis & Felix Kubler & Paul Willen, 2005. "Borrowing costs and the demand for equity over the life cycle," Working Papers 05-7, Federal Reserve Bank of Boston.
  2. R. Mehra & E. Prescott, 2010. "The equity premium: a puzzle," Levine's Working Paper Archive 1401, David K. Levine.
  3. Alexander Michaelides & Francisco J. Gomes, 2005. "Optimal life cycle asset allocation : understanding the empirical evidence," LSE Research Online Documents on Economics 193, London School of Economics and Political Science, LSE Library.
  4. Sule Alan, 2005. "Entry Costs and Stock Market Participation Over the Life Cycle," Working Papers 2005_1, York University, Department of Economics.
  5. Luca Benzoni & Pierre Collin-Dufresne & Robert S. Goldstein, 2007. "Portfolio Choice over the Life-Cycle when the Stock and Labor Markets Are Cointegrated," Journal of Finance, American Finance Association, vol. 62(5), pages 2123-2167, October.
  6. Hansen, G D, 1993. "The Cyclical and Secular Behaviour of the Labour Input: Comparing Efficiency Units and Hours Worked," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 8(1), pages 71-80, Jan.-Marc.
  7. Gomes, Francisco J & Michaelides, Alexander, 2005. "Optimal Life-Cycle Asset Allocation: Understanding the Empirical Evidence," CEPR Discussion Papers 4853, C.E.P.R. Discussion Papers.
  8. Luca Benzoni & Pierre Collin-Dufresne & Robert S. Goldstein, 2007. "Portfolio choice over the life-cycle when the stock and labor markets are cointegrated," Working Paper Series WP-07-11, Federal Reserve Bank of Chicago.
  9. Bodie, Zvi & Merton, Robert C. & Samuelson, William F., 1992. "Labor supply flexibility and portfolio choice in a life cycle model," Journal of Economic Dynamics and Control, Elsevier, vol. 16(3-4), pages 427-449.
  10. Samuelson, Paul A, 1969. "Lifetime Portfolio Selection by Dynamic Stochastic Programming," The Review of Economics and Statistics, MIT Press, vol. 51(3), pages 239-46, August.
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