Wage risk and portfolio choice: The role of correlated returns

Abstract

From standard portfolio-choice theory, it is well-understood that background risk, primarily 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 a 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 find no significant effect of the correlation between wage risk and financial market risk on portfolio choice, providing evidence that this may be attributed to a lack of salience. Furthermore, our subgroup analysis reveals heterogeneity in responses, with higher-educated and risk-averse individuals showing a stronger reaction to wage risk while responses to correlation mildly vary by risk attitude.