Hedging Permanent Income Shocks

The exposure of earnings to an aggregate shock implies co-movements across individuals’ income shocks. We model such co-movements to estimate the individual correlations between permanent earnings shocks and a latent aggregate shock. We similarly estimate their correlations with stock market returns. These correlation estimates retain statistical significance in predicting both portfolio choice and participation when other measures do not. They explain participation both out-of-sample and for the same individual over time. Results, based on both Dutch and US data, support the theoretical prediction that individuals rely on asset markets to help hedge their earnings’ shocks.