Put this together to keep it straight in my head. Fairly intuitive, but maybe it will help you too… Factor that affects human capital - value of factor - allocation to risk-free asset - demand for life insurance (face value of life insurance policy) factor ---------------------- value — risk-free asset — life insurance bequest motive --------- higher -------- unch -------------- higher risk aversion ------------- higher -------- higher ------------ higher age ------------------------ higher -------- higher ------------ lower financial wealth --------- higher -------- higher ------------ lower p of wages & stocks — higher -------- higher ------------ lower implications: – make asset allocation and life insurance decisions jointly – investors should invest financial assets in a way to diversify and balance human capital – if stock market does well, investor’s financial wealth grows, should reduce % invested in stocks – investor with human capital highly correlated with stocks should reduce % to risky assets and increase % to assets less correlated with stocks
“Higher Finacial wealth and you would invest in risk free assets” - Does not sound correct/intuitive to me?
The thinking on higher financial wealth - higher allocation to risk-free asset is that higher financial wealth reduces the percentage of total wealth represented by human capital. So a higher allocation to the less risky asset is needed to make up the difference. Another way to think of it is that as initial wealth rises, the allocation to the risky asset to offset human capital becomes smaller because human capital becomes a smaller part of total wealth. If the allocation to the risky asset becomes smaller, the allocation to the risk-free asset rises. This is definitely the less intuitive of the factors, but makes sense in this way.
Awesome. Makes sense. We are looking from the perspective of HC. Thanks for sharing.
Doesn’t it depend whether your human capital acts like “a risky asset” or like “a risk-free bond”? In the case, when it acts like a risk-free bond (professor tenure), increase in financial wealth (say I won $1million) will increase the risk-free allocation even further… hence, you would want to take higher risk with your financial wealth… no? By the way, someone previously posted a great intuitive way of looking at human capital and insurance demand… If your salary is correlated with the equity market, your human capital is considered a risky-asset; hence, you use a higher discount rate to come up with the present value of your future income… this leads to lower human capital… and lower human capital demands less insurance… in this case you would want to invest in less risky assets… Now if you are a professor who is on tenure, you are pretty much guaranteed to receive an income stream for life… this means, you are using a risk-free rate as your discount rate, which leads to higher human capital value… in this case, you would want to buy life-insurance… and invest in more risky assets… I don’t know if I am making sense here… all of your great comments are welcome!