Abstract
AbstractThis chapter explores financial asset allocation strategies when human wealth, the expected present discounted value of future labour earnings, is not tradable. Investors should adjust explicit asset holdings to compensate for their implicit holding of human capital and reach the desired allocation of total wealth. Riskless labour income makes human capital equivalent to an implicit holding of safe assets, thereby creating a strong tilt in the financial portfolio towards risky financial assets. Idiosyncratic labour income risk, uncorrelated with financial asset returns, can reduce this tilt but not reverse it; positive correlation between labour income and financial asset returns can reverse the tilt, increasing the demand for safe financial assets. The ability to adjust labour supply makes investors more tolerant of financial risk, because they can respond to poor investment results by increasing work effort, while subsistence needs to act like negative labour income and reduce tolerance for financial risk.
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