Why Do Households with Risky Labor Income Take Greater Financial Risks?

Abstract

US households with high unconditional and cyclical labor income risk are more leveraged and allocate a greater share of their financial assets to stocks. I use self-reported risk preferences to show that rational sorting of risk tolerant workers into risky employment is responsible for this otherwise puzzling result. With risk preferences accounted for, the evidence suggests that households with greater permanent income variance reduce leverage and stock allocations to an extent consistent with theory. However, household portfolios and employment selection do not respond significantly to any of the other three forms of labor income risk I measure: disaster risk, permanent income cyclicality, and permanent income variance cyclicality.

Keywords: labor income risk, household risk taking, portfolio composition, risk preferences

JEL Classification: D12, D91, G11, J30