Human capital risk and portfolio choice

This work extends the literature on portfolio choice by addressing the fact that investors hold an implicit investment in a risky asset, their human capital. I empirically investigate whether labor income risk affects household portfolio choices. This work also addresses how to assess the risk inherent in human capital and the interaction of liquidity constraints and income risk in portfolio choice.; The main contribution of this dissertation is the explicit examination of the market risk associated with human capital. I calculate a “beta” measure that incorporates the covariance of labor income with the S&P500. This beta measures the sensitivity of the stream of income from human capital to the return of the S&P500. In my analysis of non-market related risk, I consider income uncertainty, the probability of loss of income and income inequality.; I use a reduced form specification and data from the PSID, S&P500, and the SCF to determine whether these labor income risk factors are influential in the portfolio decisions of households. I find that all measures of income risk have a negative effect on the household's decision to hold equity. Specifically, market risk and income uncertainty have negative and statistically significant effects on the household's portfolio decision. There is also a negative correlation between financial constraints and equity ownership.; My findings suggest the existence of temperance as defined by Kimball (1993) in household behavior when confronted with income risk. The results also suggest that households adjust their portfolios with the market risk of their human capital in mind. Though statistically significant, the size of the effects of income risk on equity demand are too small to explain the historical under-investment in stocks and low participation in the stock market.; If the marginal changes found in this work are applied to the 1989 U.S. economy as a whole, a doubling of the market risk of human capital would cause an outflow of {dollar}8 billion from the equity market. If income uncertainty is doubled, there would be an exodus of up to 6.8 million households from the equity market.