Optimal Life-Cycle Portfolios for Heterogeneous Workers

Abstract

Household portfolios include risky bonds, beyond stocks, and respond to permanent labour income shocks. This paper brings these features into a life-cycle setting, and shows that optimal stock investment is constant or increasing in age before retirement for realistic parameter combinations. The driver of such inversion in the life-cycle profile is the resolution of uncertainty regarding social security pension, which increases the investor’s risk appetite. This occurs if a small positive contemporaneous correlation between permanent labour income shocks and stock returns is matched by a realistically high degree of risk aversion. Absent this combination, the typical downward sloping profile obtains. Overlooking differences in optimal investment profiles across heterogeneous workers results in large welfare losses, in the order of 15-30% of lifetime consumption.

Keywords: Life-cycle portfolio choice, background risk, age rule, investor heterogeneity

JEL Classification: G11