Portfolio Selection with Risky Labor Income

Sammanfattning: By accounting for the size of future wages and their covariance with other assets, a Swedish investor can increase his or her certainty equivalent of total wealth by between 3 and 89 basis points on an annualized basis, given stable risk-return relationships and depending on a number of factors. We develop a two-period model which accounts for multiple risky future wages and multiple risky assets. Investor utility is constructed as a function of wealth and variance of consumption. For 12 wage sectors, we then optimize the financial portfolio under two scenarios, one in which human capital is not a component and one in which it is. We find that there are substantial gains to be made from considering human capital in the portfolio selection decision, and confirm that human capital constitutes a significant portion of both investor total wealth and variance of consumption. However, the magnitudes of the realizable gains remain dependent on the quality of model inputs.