Modeling human capital in life-cycle portfolio choice: Riskless or risky?

We study the impact of risky human capital in life-cycle portfolio choice and survey the academic literature on the optimal asset allocation over the individual’s life-cycle, where we emphasize the nature of human capital. A distinction is made between the riskless conception of human capital as having bond-like characteristics, and the risky conception of seeing this future income stream as having stock-like properties. In particular, attention will be paid to the models presented in Cocco, Gomes, and Maenhout (2005) and Benzoni, Collin-Dufresne, and Goldstein (2007). We use the idea of Benzoni et al. to study the welfare implications of portfolio choice when labor income and dividends are co-integrated. This dynamic portfolio choice problem is analyzed for two sectors, public and construction, and for the Netherlands as a whole. The results indicate that hump-shaped asset allocations are welfare improving for all three groups. Further, we show that similar conclusions are obtained using a simple vector autocorrection model.