A Realistically Calibrated Life Cycle Model of Portfolio Allocation and Consumption with Stochastic Non-Financial Income:

University essay from Handelshögskolan i Stockholm/Institutionen för finansiell ekonomi

Abstract: We analyze the effect of uninsurable stochastic non-financial income on the risky asset share in a life cycle model of portfolio allocation and consumption. The model is calibrated empirically using German data. We quantify the risk of non-financial income and show that this risk is largely idiosyncratic. Females face larger income shocks than males. Human capital has a significant effect on portfolio composition. Unless we allow non-financial income to drop to zero, the optimal risky share is close to 100% early in life as investors' wealth consists mostly of human capital. The optimal risky share decreases in subsequent years as agents build up financial wealth, but this effect partly reverses during retirement despite smaller human capital, because financial wealth is drawn down again. The utility costs of maintaining a constant risky asset share or of following rules of thumb for life cycle investing are economically large.

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