By Yongsung Chang, Jay Hong and Marios Karabarbounis
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.
Often neglected in portfolio theory, labor income risk appears to be critical to understand portfolio choices over the life cycle. It not only the fact that younger people do not have the means to invest in financial assets, the paper here shows that the uncertainly about the path of future labor income is overwhelming at first and then vanishes as they learn it over time. It is only then that they can afford financial asset return risk.