Under these conditions, Merton (1969) shows that the optimal share invested in stocks is given

by
μ−r
α= . 5.
γσ2
This equation is referred to as the Merton rule.

2.2. Optimal Portfolio Choice with Labor Income in a One-Period Model

In this section, we introduce labor income in the portfolio choice model. To simplify the exposi-
tion, we consider a one-period model, with end-of-period wealth given by
W1 = [αR1 + (1 − α)R f ]W0 + Y1 , 6.
Annu. Rev. Financ. Econ. 2020.12:277-304. Downloaded from www.annualreviews.org

where Y1 is labor income in period 1 and R1 and Rf are, respectively, the gross returns on a risky
Access provided by Arizona State University on 10/21/21. For personal use only.

and a riskless asset.

2.2.1. Riskless labor income. I first considered the case of riskless labor income, i.e., where Y1
is a constant. The optimization problem is

([αR1 + (1 − α)R f ]W0 + Y1 ) 1−γ
Max f (R1 )dR1 , 7.
α 1−γ
where f denotes the pdf of the return distribution. The first-order condition (f.o.c.) is
  
−γ
Y1
αR1 + 1 − α + R f W0 (R1 − R f ) f (R1 )dR1 = 0. 8.
R f W0
And this can be further rewritten as

 −γ
α R1 + (1 − 
 α )R f (R1 − R f ) f (R1 )dR1 = 0, 9.

where
α

α≡ Y1
. 10.
1+ R f W0

The f.o.c. in Equation 9 is identical to the one we would obtain for α, in a model with Y1 = 0, so
the two solutions must be the same. Therefore, denoting the solutions in the labor-income and
no-labor-income cases by α Y and α NY , respectively, we have


αY PV (Y1 )
= αNY ⇐⇒ αY = 1 + αNY . 11.
1 + R YW1 W0
f 0

From Equation 11, we conclude that the present value of future riskless labor income is like an
extra endowment of the safe asset. Therefore, the investor readjusts their financial portfolio so
that the share of total wealth invested in risky securities is the same as when all wealth (including
labor income) is tradeable (Merton 1971).

2.2.2. Risky labor income. When we consider risky labor income, the optimal portfolio allo-
cation is determined both by the correlation between future labor income realizations and stock
returns and by the variance of labor income.
To understand the effect of correlation, we now consider the case where wages are perfectly
correlated with the return on the risky security (Y1 = Y R1 ). (This case is considered in Bodie,
Merton & Samuelson 1992.) Repeating the algebra in Section 2.2.1 we have the reverse result,
www.annualreviews.org • Portfolio Choice Over the Life Cycle 279