Popular investment advice recommends that the stock/bond and
stock/wealth ratios should
rise with investor risk tolerance and investment horizon respectively,
prescriptions that are difficult to reconcile with the simple
mean-variance model. We show that extending the
mean-variance model to include human capital, without any other
modifications, can simultaneously justify both recommendations, so long
as the correlation between labour income and stock returns falls within a
range determined by market and investor-specific parameters.
Aggregate labour income data from 11 countries generally satisfy this
requirement, as do plausible individual income processes. We also
consider the implications of human capital for the optimal bond/wealth
ratio over the investment horizon, and examine the sensitivity of the
stock/bond mix to the volatility of labour income.
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