License to Spend: Consumption-Income Sensitivity and Household Portfolio Choice

Abstract

Contrary to the predictions of traditional life-cycle models, households do not engage in perfect consumption smoothing. Similarly, weak evidence of income hedging runs against standard portfolio theory. We link these two puzzles by proposing a model in which investors derive utility from consumption and income status. In contrast to the traditional life-cycle model, status conscious investors use financial assets to either over- or under-hedge income fluctuations, depending on whether they treat consumption and status as complements or substitutes. We confirm the predictions of the status preference model using data from the PSID, and find that status preferences empirically affect the income hedging motive in household portfolio decisions.