Life-cycle Portfolio Research Articles

Fractional Homeownership and its Impact on Life Cycle Portfolio Choice

Fractional Homeownership and its Impact on Life Cycle Portfolio Choice

Life-Cycle Portfolio Choice with Stock Market Loss Framing: Explaining the Empirical Evidence

Life-Cycle Portfolio Choice with Stock Market Loss Framing: Explaining the Empirical Evidence

Stock market participation: The role of human capital

While human capital accumulation is significant early in life, stock market participation is limited. As individuals age, this pattern is reversed. In this paper, we show that—when disciplined to match the substantial heterogeneity observed in earnings—a life-cycle portfolio choice model augmented to allow human capital investment delivers stock market participation over the life-cycle consistent with the data. Key to our finding is that returns to human capital, unlike those to stocks, depend on both individual characteristics and the amount of time invested. Our results also suggest that when human capital accumulation is endogenous, it is short sales constraints on stocks, and not borrowing constraints, that limit engagement with the stock market.

On Optimal Allocations of Target-Date Funds

We study optimal life-cycle portfolio allocation and its application to target-date fund (TDF) design. We show that optimal TDF allocation must be explicitly linked to a savings rate; for example, a higher savings rate generating higher financial wealth accumulation should necessarily come with a more conservative TDF. Further, we quantify the extent to which accumulated wealth, the investing environment, and participant characteristics affect TDF allocations and compare the resulting optimal allocations against the observed universe of US TDF products. Plan sponsors and asset managers can use these findings to improve TDF selection and design. <b>Key Findings</b> ▪ We quantify how observed savings rates in 401k plans affect a TDF’s optimal allocation. Using a state-of-the-art life-cycle academic model, we find strong effects: for a moderately risk-averse participant, a halving in savings rate from 10% to 5% increases its optimal equity allocation by 10%–15%. ▪ We document the effects of real-life variations in other key determinants of TDF optimal allocations: participant’s risk aversion, relation between wages and equity returns, outside retirement income, start of savings, and expected returns. We measure the resulting wealth and consumption experience at and in retirement. ▪ We set these optimal glide paths against the glide paths pursued by US TDF mutual funds and observe a much narrower range for the observed ones, thus leaving some constituencies without an appropriate investment choice. Further, the optimal glide paths tend to slow the equity decline as they approach retirement; most observed ones do the opposite.

Profitability of moving-average technical analysis over the firm life cycle: Evidence from Taiwan

Using a sample of Taiwanese listed firm stocks during 1992–2018, this paper tests the profitability of the moving average (MA) technical analysis over the firm life cycle (FLC). Building on the Dickinson (2011) FLC measure of, the results indicate a U-shape of MA profitability over the FLC—MA abnormal performance is higher in the introduction and shakeout/decline stages but lower in the growth and mature stages. Such a U-shape remains after controlling for various risk factors, such as the Fama–French five factors, the momentum factor, and the liquidity factor. The results of this study are robust to alternative lag length specifications for the MA, life cycle proxy, sub-period selection, equally/valued weighted sorted life-cycle portfolio, and various market stats, such as bullish/bearish market periods, high/low market volatility, and expansion/recession economic cycles. The overall results support the information uncertainty hypothesis and the dynamic resource-based life-cycle theory, postulating that a trend-chasing MA strategy is more profitable for firms in the introduction and shakeout/decline stages that are characterized by greater information uncertainty and, thus, longer underreaction-driven price continuation.

Optimal Target-Date Funds for Observed Savings Rates

We study optimal life-cycle portfolio allocation and its application to target-date fund (TDF) design. We show that optimal TDF allocation must be explicitly linked to a savings rate; for example, a higher savings rate generating higher financial wealth accumulation should necessarily come with a more conservative TDF. Further, we quantify the extent to which accumulated wealth, the investing environment, and participant characteristics affect TDF allocations and compare the resulting optimal allocations against the observed universe of U.S. TDF products. Plan sponsors and asset managers can use these findings to improve TDF selection and design.

Optimal Portfolio Choice With Path-Dependent Labor Income: Finite Retirement Time

This paper extends the project initiated in and studies a lifecycle portfolio choice problem with borrowing constraints and finite retirement time in which an agent receives labor income that adjusts to financial market shocks in a path dependent way. The novelty here, with respect to, is the fact that we have a finite retirement time, which makes the model more realistic, but harder to solve. The presence of both path-dependency, as in, and finite retirement, leads to a two-stage infinite dimensional stochastic optimal control problem, a family of problems which, to our knowledge, has not yet been treated in the literature. We solve the problem completely, and find explicitly the optimal controls in feedback form. This is possible because we are able to find an explicit solution to the associated infinite dimensional Hamilton-Jacobi-Bellman (HJB) equation, even if state constraints are present. Note that, differently from, here the HJB equation is of parabolic type, hence the work to identify the solutions and optimal feedbacks is more delicate, as it involves, in particular, time-dependent state constraints, which, as far as we know, have not yet been treated in the infinite dimensional literature. The explicit solution allows us to study the properties of optimal strategies and discuss their financial implications.

Portfolio Choice Over the Life Cycle: A Survey

Life-cycle portfolio choice models capture the role of human capital, housing, borrowing constraints, background risk, and several other crucial ingredients for determining the savings and investment decisions of households. Over the last two decades, this literature has provided us with multiple insights regarding the asset allocation decisions of individual investors. This article provides a critical survey of this research and suggests directions for future research, namely incorporating additional forms of household heterogeneity.

Forced retirement risk and portfolio choice

Abstract Current literature on the effect of labor income on portfolio choice overlooks that workers face a risk of being forced to retire before their planned retirement age. Using data from the Health and Retirement Study, this paper finds that the forced retirement risk is both significant and highly correlated with stock market fluctuations. Using a life-cycle portfolio choice model, this paper shows that forced retirement risk makes labor income near retirement stock-like. Therefore, contrary to conventional wisdom, those who are still working but near retirement should have a lower share of risky assets in their financial portfolios than retirees do.

Time-Varying Relative Risk Aversion: Mechanisms and Evidence

This paper explores theoretically and empirically the issue of time-varying relative risk aversion. We analytically solve a parsimonious life-cycle portfolio choice model with the preferences given by Greenwood, Hercowitz and Huffman (1988, GHH). Our analytical solution identifies four partial equilibrium effects in our model with GHH preferences on risky shares through two channels, and two net effects whose signs hinge on the value of a key structural parameter. With household-level micro data, our mean and quantile regression results show that wealth negatively affects risky shares and the estimated effects are statistically significant and robust. This finding provides strong evidence to support our theoretical prediction. Thus, we show successfully that our portfolio choice model with GHH preferences provides a plausible underlying mechanism in understanding the wealth effect on risky shares in the microdata. Furthermore, we conclude that such a mechanism alone is not sufficient in explaining how risky shares respond to labor income and labor income risks in the microdata.

Risk reduction in two-pillar mandatory pension system under regulatory constraints: simulation-based evidence from Poland

ABSTRACT The regulatory framework of the Polish pension system is far-removed from the optimal lifecycle portfolio approach, which recommends a time-varying asset mix to minimize portfolio risk. Nevertheless, a question emerges on how large diversification gains can grow under the existing rules. This study accounts for the current restrictions and estimates risk-reduction opportunities under the two-pillar pension system. We compare the outcomes with our previous results for optimal portfolio allocation and, as in the previous study, use a Monte Carlo approach with a copula function to simulate the distribution of replacement rates for the Polish pension system. We conclude that the regulations hinder, to a significant extent, the opportunity to minimize shortfall risks, an unsatisfactory outcome for Polish pensioners.

Demographic Impacts on Life Cycle Portfolios and Financial Market Structures

This paper provides a framework to endogenize rates of return for risk-free bonds and risky capital in an overlapping generation model. The rate of return on capital is endogenized by introducing idiosyncratic production shocks to avoid computation challenges associated with aggregate production shocks in the literature. The framework enables the interaction between financial markets and macroeconomic conditions in a production economy. Based on this framework, the paper first examines life-cycle portfolio choice without demographic change, and illustrates that several factors such as borrowing costs, labor income and production risk play important roles in life-cycle portfolios. The paper then investigates the impacts of population aging on macroeconomic conditions, life-cycle behaviors and financial market structures. The results show that population aging leads to higher capital-labor ratios, and reduces the rates of return on both assets. The bond market shrinks significantly, and capital decreases if the fertility rate declines but increases if the mortality rate declines, leading to structural change in financial markets. The impacts on life-cycle variables are quite different in the fertility and mortality cases particularly at the late stage of life.

Portfolio choice after retirement: Should self-annuitisation strategies hold more equities?

We compare the performance of alternative investment strategies in the decumulation phase for retirees who self-annuitise. We find that portfolios with constant high exposure to equities, as well as portfolios that increase exposures to equities over time, consistently outperform conservative portfolios which avoid investment in equities or the conventional lifecycle portfolios which reduce allocation to equities over time. While an increasing equity glidepath improves the performance of an investment strategy, the allocations to equities at the start of retirement is critical. Using a ‘utility of terminal wealth’ approach that allows for loss aversion as in prospect theory of Kahneman and Tversky (1979), we find a growth portfolio with very high (but not total) exposure to equities to dominate the alternative strategies at low and moderate thresholds. With further increases in wealth threshold levels, a strategy with an all equity allocation becomes dominant. The lifecycle portfolio is dominated by the ‘reverse lifecycle’ portfolio at all threshold levels. Finally, for retirees who defer annuitisation, we find strategies with a higher equity component have greater likelihood of outperforming an immediate annuitisation strategy in terms of generating a guaranteed income late in retirement.

The Effect of Uncertain Labor Income and Social Security on Life-Cycle Portfolios

This paper examines how labor income volatility and social security benefits can influence lifecycle household portfolios. We examine how much the individual optimally saves and where, taking into account liquid financial wealth and annuities, and stocks as well as bonds. Higher labor income uncertainty and lower old-age benefits boost demand for stable income in retirement, but also when young. In addition, a declining equity glide path with age is appropriate for the worker with low income uncertainty; for the high income risk worker, equity exposure rises until retirement. We also evaluate how differences in social security benefits can influence retirement risk management.

Life-cycle portfolios, unemployment and human capital loss

The recent Great Recession highlighted that long-term unemployment spells may entail persistent losses in workers’ human capital. This paper extends the life-cycle model of savings and portfolio choice with unemployment risk, by allowing the possibility of permanent reductions in expected earnings following long-term unemployment. The optimal risky portfolio share becomes flat in age due to the resolution of uncertainty about future returns to human capital that occurs as the worker ages. This may help explaining the observed relatively flat, or only moderately increasing, risky share of investors during working life, and have important consequences for the design of optimal life-cycle portfolios by investment funds.

GHH Preferences on Households' Portfolio Choices: Theoretical Implications and Empirical Evidence

This paper explores theoretical implications and empirical evidence of GHH preferences [Greenwood et al. (1988)] over portfolio choices. First, we analytically solve a parsimonious life-cycle portfolio choice model with the GHH preferences and endogenous labor-leisure choice. Second, our analytical solution identifies four effects due to the GHH preferences (through endogenous labor-leisure choices) on risky shares; and it shows that two net effects hinge on the value of one key structural parameter. Third, we empirically test main theoretical predictions with the Panel Study of Income Dynamics data. Overall, the estimation results provide empirical evidence in support of certain key implications out of GHH preferences. Thus, our analysis sheds light on one of the most fundamental, yet highly contentious, questions in quantitative macroeconomic analysis: the choice of utility functions in a representative agent model when portfolio choices are of concern.

Limited Stock Market Participation Among Renters and Homeowners

Abstract The stock market participation rate among homeowners is twice as high as among renters. This paper builds a life-cycle portfolio choice model with endogenous housing tenure choice. A stylized form of preference heterogeneity generates a substantial difference in participation rates. A majority of households have a large savings motive and choose to be homeowners and participate. A minority of households have a small savings motive and find it less worthwhile to participate. Fewer of these households become homeowners. Difference-in-difference regressions on panel data do not find evidence of a crowding-out effect of homeownership on participation, supporting the message that preference heterogeneity matters. Received January 25, 2017; editorial decision March 21, 2018 by Editor Wei Jiang. Authors have furnished an Online Appendix, which is available on the Oxford University Press Web site next to the link to the final published paper online.

Investor's Demographics and Portfolio Objectives: An Empirical Study Using Factor Analysis

Demographics affect Investor’s psychology thereby affecting portfolio choices made by investors. In a survey of 512 retail investors, it was found that Risk bearing capability affects choice among portfolio objectives most and Years to Retirement influences this choice least. “R” factor analysis has been undertaken to reduce the originally identified eight factors into minimum number of factors influencing portfolio objectives. Timing of Portfolio, Security from Portfolio, Knowledge of Portfolio Selection and Life Cycle Portfolio were finally identified as four factors affecting Portfolio Objectives.

The Luxury of Bequest

Households with higher permanent income exhibit increased saving rates, a fact that can be explained by the assumption that households treat bequest as a luxury good. This paper provides evidence supporting this assumption, in the context of a life-cycle portfolio choice model. Households choose to save at the risk-free rate, invest on a risky asset or purchase life insurance and the luxury good property is governed by the relative risk aversion of the bequest function, which is lower than the one of the utility of consumption. Using the Method of Simulated Moments, I structurally estimate the two relevant risk aversion parameters, matching moments generated by the model to their empirical counterparts. I find that the parameters are unequal in the predicted direction and in a statistically significant way. When compared to a standard, homothetic model, the luxury-of-bequest specification generates improved average profiles and more a realistic wealth distribution.

Life-Cycle Consumption and Portfolio Choice with an Imperfect Predictor

I study the effect of observable predictors that imperfectly predict conditional expected stock returns on optimal life-cycle consumption and portfolio choice in the presence of undiversifi able labor income risk. Investors filter the unobservable expected stock returns from realized predictive variables and stock returns. Young stockholders hold more conservative portfolios, better matching empirical observations, than models assuming a predictor perfectly delivering the conditional expected stock return or models assuming i.i.d. stock returns. Welfare losses from ignoring imperfect predictability can be substantial.