Portfolio Choice Over the Life-Cycle in the Presence of Cointegration between Labor Income and Inflation

Abstract

We study portfolio choice for a finite-horizon investor whose labor income is cointegrated with inflation. We show that this long-run relationship has substantial impact on the riskiness of human capital and consequently on the optimal portfolio strategy. Because cointegration raises the long-run correlation between human capital and inflation, young investors’ human capital effectively hedges inflation risk and crowds out the allocation to inflation-indexed bonds. However, the hedging power of human capital diminishes for older investors because of a weaker cointegration effect and less importance of human capital in total wealth. These effects together show that inflation-indexed bonds matter more for older investors than for young investors.