Optimal portfolio choice with asset return predictability and nontradable labor income

Hui Ju Tsai, Yangru Wu

Research output: Contribution to journalArticlepeer-review

7 Scopus citations

Abstract

We study the optimal consumption and investment choice for long-horizon investors with nontradable labor income and time-varying investment opportunities. Our results suggest that the popular investment recommendation that more conservative investors should hold a higher bond/stock ratio may lack theoretical justification when labor income is considered. When labor income is positively correlated with stock returns, a more risk-averse investor holds a higher bond/stock ratio in her risky portfolio, but the reverse is true when labor income is positively correlated with bond returns. The allocation to stock inherits the inverted U-shaped pattern of labor income growth with respect to expected time until retirement. Investors with lower income growth, namely, younger workers or those near retirement, should invest less in risky assets than those who are in their mid career and have a higher income growth. Performance test shows that the welfare loss of ignoring asset return predictability in the presence of nontradable labor income can be economically significant.

Original languageEnglish (US)
Pages (from-to)215-249
Number of pages35
JournalReview of Quantitative Finance and Accounting
Volume45
Issue number1
DOIs
StatePublished - Jul 1 2015

All Science Journal Classification (ASJC) codes

  • Accounting
  • Business, Management and Accounting(all)
  • Finance

Keywords

  • Life cycle
  • Nontradable labor income
  • Portfolio choice
  • Return predictability

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