Life-Cycle Asset Allocation: A Model with Borrowing Constraints, Uninsurable Labor Income Risk and Stock-Market Participation Costs

Abstract

We study life-cycle asset allocation in the presence of liquidity constraints and undiversifiable labor income risk. The model includes three different assets (cash, long-term government bonds and stocks) and it takes into account the life-cycle profile of housing expenditures. With a modest correlation between stock returns and earnings innovations, the mean share of wealth invested in stocks never exceeds 45% during working-life. Moreover, the combination of uninsurable human capital and borrowing constraints rationalizes the asset allocation puzzle of Canner, Mankiw and Weil (1997). Nevertheless we argue that asset allocation models must match another important feature of the data: a low stock market participation rate. Along this dimension the model provides a very modest improvement, still predicting a counterfactually high participation rate. We show that this arises from the link between risk aversion and prudence, implying that explanations for the participation puzzle based on the role of background risk are unlikely to succeed.