Wealth Fluctuations and Risk Preferences: Evidence from U.S. Investor Portfolios

Abstract

Using data on the portfolio holdings and income of millions of U.S. retirement investors, I find that positive and persistent shocks to income lead to a significant increase in the equity share of investor portfolios, while increases in financial wealth due to realized returns lead to a small decline in the equity share. In a standard homothetic life-cycle model with human capital and constant risk aversion, the portfolio responses to these two wealth shocks should be of equal magnitude and opposite sign. The positive net effect in the data is evidence for risk aversion that decreases in total wealth. I estimate a structural life-cycle consumption and portfolio choice model that accounts for inertia in portfolio rebalancing and matches the reduced-form estimates with a significant degree of non-homotheticity in risk preferences, such that a 10% permanent income growth leads to an average decrease in risk aversion by 1.7%. Decreasing relative risk aversion preferences concentrate equity in the hands of the wealthy and double the share of wealth at the top of the wealth distribution.