Life-cycle Investing with Personal Disaster Risk

Abstract

This paper extends the life-cycle model by allowing for a small risk of a personal disaster with permanent effects on labour income. We calibrate the model to long-term unemployment (LTU) in the US, where it is only partially insured and is known to entail scarring effects. Despite its low probability, such risk boosts early investment in the risk-free asset. Consequently, the optimal equity portfolio share is relatively flat over the life cycle, consistent with observed investment profiles. A negligible probability of LTU or full insurance against it result in both higher optimal risk taking and equity profiles that are downward sloping in age.