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Wage Risk and Portfolio Choice: The Role of Correlated Returns

Johannes König and Maximilian Longmuir

No 1974, Discussion Papers of DIW Berlin from DIW Berlin, German Institute for Economic Research

Abstract: From standard portfolio-choice theory it is well-understood that background risk, overwhelmingly due to wage risk, is one of the central determinants of individuals’ portfolio composition: higher background risk reduces risky investments. However, if background risk is negatively correlated with financial market risk, higher background risk implies more risky investment. We quantify the influence of wage risk on German investors’ financial portfolio shares and find that an increase of the residual variance of wages by one standard deviation implies a reduction of the financial portfolio share by 3 percentage points. We do not find that the correlation of wage risk with financial market risk has a significant impact on portfolio choice and provide evidence that this may be due to a lack of salience.

Keywords: Background risk; portfolio choice; household portfolios; investment behavior (search for similar items in EconPapers)
JEL-codes: D12 D14 D31 (search for similar items in EconPapers)
Pages: 33 p.
Date: 2021
New Economics Papers: this item is included in nep-cwa, nep-his, nep-rmg and nep-upt
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