Countercyclical Risks and Optimal Life-Cycle Profile: Theory and Evidence

Abstract

I show that countercyclical earnings risk alone can cause countercyclical consumption risk and generate moderate stock holdings for young households. Moreover, countercyclical earnings risk quantitatively affects savings and portfolio choice decisions over the business cycle. Using the Panel Study of Income Dynamics survey, I construct an empirical measure of earnings risk and investigate how consumption risk and households' portfolio allocations and consumption change in response to earnings risk. My analysis shows that larger downside earnings risk increases consumption risk and reduces risky asset holdings and consumption, which are consistent with the model's predictions. Moreover, countercyclicality in consumption risk is more significant for stockholders than for nonstockholders. Using the flexibility of the model, I find that the elasticity of intertemporal substitution and the expected return of a stock can explain this heterogeneity between stockholders and nonstockholders.