Life Cycle Portfolio Choice under Future Labor Income Ambiguity

Abstract

This paper aims to establish a unified framework on life-cycle portfolio choice which is compatible with two phenomena simultaneously: the non-participation puzzle and hump-shaped risky asset holdings over the life cycle. The previous studies usually have dealt with them separately, investigating the non-participation without the life cycle consideration and vice versa. The fact that the participation rate and the proportion of risky assets are increasing functions of age, however, calls for integrated explanations on both. This paper suggests a simple finite horizon model in which the agent faces ambiguity about human capital, especially about the correlation between the market return and return on human capital. The results support that non-participation could be optimal in the presence of ambiguity and the weight in risky assets exhibits hump-shape over the life cycle. This model contributes to the existing literature in the sense that the non-participation is derived as a result of the agent's optimization, without any assumptions on market frictions. Another remarkable feature is that the model does not require a high correlation between the market return and labor income. It can be easily extended to a model that explains differences in participation decisions among the agents within the same age group.