with labor income substituting for stock holdings.

Consequently, it is the share invested in bonds

that is now increased:
 
Y
(1 − αY ) = 1 + (1 − αNY ). 12.
W0

From Equations 11 and 12, we conclude that the net effect depends on the sign and magnitude
of the correlation between stock returns and labor income shocks.3 The estimates of this correla-
tion by Campbell et al. (2001) and Davis & Willen (2013) are very close to zero for the average
household, indicating that labor income is a closer substitute for riskless bonds than for stocks.
In classical portfolio choice theory, idiosyncratic risk is irrelevant because all wealth is trade-
able and therefore agents can hold a diversified portfolio. However, labor income risk is largely
undiversifiable, i.e., agents cannot trade assets or write contracts to insure it, and this gives rise to
a background risk effect. Under fairly common assumptions about investor preferences (see Pratt
Annu. Rev. Financ. Econ. 2020.12:277-304. Downloaded from www.annualreviews.org

& Zeckhauser 1987, Kimball 1993, Gollier & Pratt 1996), labor income risk or any other source
Access provided by Arizona State University on 10/21/21. For personal use only.

of background risk (e.g., expenditure shocks) crowds out asset allocation risk, i.e., implies a more
conservative portfolio allocation. Viceira (2001) extends this result to infinite horizon models with
portfolio choice and intermediate consumption. Readers are also referred to work by Heaton &
Lucas (1996) and Haliassos & Michaelides (2003).

3. BASELINE LIFE-CYCLE PORTFOLIO CHOICE MODEL

3.1. Model Setup
I first present the basic life-cycle model of consumption and portfolio choice with unspanned risky
labor income and borrowing constraints, as introduced by Cocco, Gomes & Maenhout (2005).4
The investor has a finite horizon (T) and receives an exogenous labor income every period (Yt ).
Before retirement, (t < K) labor income is stochastic, while after retirement it is constant.5 The
investor faces both borrowing and short-selling constraints and can invest in two assets: a risky
asset (stocks) and a riskless asset (bonds).

3.1.1. Preferences and budget constraint. The investor is solving

⎛ ⎞

T  t
Ct1−γ
Max E β t−1 ⎝ π j ⎠ , 13.
T
{Ct,αt }t=1
t=1 j=1
1−γ

s.t. Wt+1 = [αt Rt+1 + (1 − αt )R f ](Wt − Ct ) + Yt+1 , 14.

Wt ≥ 0, αt ∈ [0, 1], 15.

Rt = μ + R f + εt , where εt ∼ N (μ, σR2 ), 16.

3 This simple static model suggests the following rule of thumb: If the correlation between labor income and

stock returns is lower (higher) than 0.5, the portfolio share invested in stocks is increased (decreased) by the
presence of labor income. But such a rule ignores the background risk effect discussed below and, since the
stochastic process for labor income is not i.i.d., in a multiperiod model the correlation structure is often more
complex.
4 For earlier life-cycle savings models without portfolio choice, readers are referred to Hubbard, Skinner &

Zeldes (1995); Carroll (1997); and Gourinchas & Parker (2002).

5 Labor income after retirement corresponds to both social security payments and payments from defined

benefit pension plans.

280 Gomes