Topic and Objectives
We study the importance of skill and luck in a rich consumption-portfolio choice problem with predictability in stock prices, house prices, and labor income. In our model, skilled investors are able to time the market and take all sources of predictability into account, whereas unskilled investors ignore predictability. Therefore, investors enter the market under quite different economic conditions. An investor's market entry date is however predetermined by his birthday so a favorable entry date is pure luck.
We thus compare investors along two dimensions: their skills and their luck to live under favorable economic conditions. We determine the welfare effects of living under the same economic conditions, but having different skills, and the welfare effects of living under different economic conditions.
- For 15 cohorts of investors entering the market between 1961 and 1976 and retiring 35 years later the certainty-equivalent welfare loss of being unskilled is between 0.3% and 6.8% with an average of 4.1%.
- The three unluckiest but skilled investors entering the market in 1973, 1974, and 1976 realized average welfare losses of 7.1%, 11.2%, and 13.0% compared to lucky but unskilled investors entering the market about ten years earlier (1963, 1964, and 1965).
- In a simulation study, we further find that in 25% of the cases a skilled investor would rather trade in skill for luck, i.e. he would rather give up all his skills to live under more favorable economic conditions.
- This paper also disentangles the welfare effects of skill and luck. We find that, if anything, house predictability is more relevant than stock predictability. Nevertheless, in our framework the welfare effect of being skilled is moderate compared to the effect of being born in favorable times. In fact, the latter effect is about 2-3 times bigger.
What are the practical implications of our findings? It can well be that neighbors of different, but similar age, might have very distinct lifestyles simply because one of them was so lucky to enter the asset markets under more favorable conditions. Even if the unlucky agent is skilled, he might not be able to compensate his bad luck of being born at the wrong time by using his skills. Although we are only considering a partial equilibrium model, this finding suggests that achieving inter-generational fairness is aggravated if different generations face different investment opportunities.
|Holger Kraft, Claus Munk, Farina Weiss||Predictors and Portfolios Over the Life Cycle|
Journal of Banking and Finance
|2019||Household Finance||Return predictability, human capital, housing, investments, welfare|
|139||Holger Kraft, Claus Munk, Farina Weiss||Predictors and Portfolios Over the Life Cycle||2016||Household Finance||Return predictability, human capital, housing, investments, welfare|