Pensions 2

Question 1

Lifecycle investment

Key lessons so far

Answer 1

If human capital is considered to be risk free then it is optimal for young workers to invest all their financial assets into risky assets (eg stocks )

The amount that young people want to invest in risky assets exceeds their financial assets, implying they want to borrow money and invest the proceeds in risky assets

Determining factors of the optimal investment strategy of young investors ;
-Risk aversión of individual
-Risk return characteristics of risky assets
Age of individual (determines importance of human capital )
- labour income risk of individual

Question 2

Factors that determine the optimal lifecycle profile

Answer 2

Financial markets :
Interest rate risk 
Inflation risk 
Mean reversion in stock returns 
Bayesian learning 

Other assets :
Home ownership

Labor markets :
Labor income risk

Labor markets:
Labor income risk
Flexible labor supply

Preferences:
Habit formation
Reference point
Subsistence consumption

Question 3

Inflation risk

Answer 3

If there are no indexes bonds available in the market (market incompleteness), and if inflation risk is considered high, then long term bonds can be unattractive for long a term investor

Reason :
If a rise in inflation leads to an increase in nominal interest rates (with real rates unchanged) then the price of long term nominal bonds falls

Question 4

Extension other assets

Answer 4

Home ownership :

A home may have similar properties as a long term (inflation linked ) bond portfolio : it provides a real consumption stream, matching costs of living. This reduces demand for (inflation linked) bonds

Home ownership : a home may have similar properties as a stock portfolio. In that case, it reduces demand for stocks

Special about investing in a house : you can invest more than your financial wealth in this risk asset (house is collateral )

Question 5

Lessons learned compared to benchmark model

Answer 5

Investing becomes more attractive for young investors:

• if human capital is safe
• if one believes in mean reversion in stock returns
• if labor supply is flexible
• if you own a house which is considered bond like

Investment becomes less attractive for young investors:

• If human capital is risk
• if human capital moves together with stock markets in the long run
• if you own a house which is considered “stock like”