Permanent income, not last year’s income, drives allocation.
A business owner who had a rough year, but whose underlying economics remain sound, should not be treated like someone whose long-term trajectory has changed. Temporary income fluctuations have almost no effect on the optimal allocation. What matters is the volatility of the permanent component of income — the durable earning power that is expected to persist over time.
This is a distinction advisers often make instinctively in conversation but rarely formalize in the portfolio.
The model also suggests that many working-age investors may be underweight equities. In many cases, it pushes allocations to 100% equities during the accumulation years, even with conservative capital-market assumptions. It is not the return forecast doing the work. It is the sheer size of human capital relative to financial wealth.
The asymmetry is striking. At a risk aversion of four — a level the authors consider reasonable for many investors — holding zero equities for life costs 7.9% of lifetime welfare. Holding 100% equities costs just 0.56%.
In other words, the model is far more forgiving of holding too much equity during the accumulation years than of holding too little. For investors whose human capital is large, stable, and bond-like, the greater liability may not be equity exposure. It may be failing to take enough of it.
But when income is correlated with the market, the answer changes. A business owner whose revenue rises and falls with the economic cycle already carries implicit equity exposure through the business. That client should generally hold less stock than a government employee with identical financial wealth. The direction is intuitive; the formula’s contribution is putting a number on the adjustment.
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