Lifecycle portfolio choice

Abstract

Using the Panel Study of Income Dynamics, I find that stockholders subject to more negative skewness in earnings growth hold a lower share of their financial wealth in stocks. Moreover, I also find that skewness in earnings growth affects the mean and skewness in consumption growth, and this effect is stronger for stockholders than nonstockholders. Using a life-cycle model incorporating business cycle variation in expected growth and skewness in earnings shocks, I investigate these relationships from an asset allocation perspective. During expansions (recessions), households consume more (less), and also invest a higher (lower) share of their wealth in the stock market, because of a higher (lower) expected future earnings growth rate. Negative skewness in the earnings process during recessions further reduces households' stock market exposure and consumption. The model shows how countercyclical skewness in earnings shocks is extremely important to match quantitatively observed portfolio choice and wealth accumulation over the life cycle, while simultaneously leading to countercyclical skewness in consumption growth. Moreover, the quantitative predictions are consistent with evidence from aggregate Flow of Funds data and match the observed degree of wealth inequality in the U.S..