The Distribution of Implied Risk Tolerance Across the Lifecycle

Abstract

The investor’s or household’s risk tolerance parameter is a key input in the lifecycle models stemming from Samuelson (1969) and Merton (1969, 1971) as well as the single period mean-variance models stemming from Markowitz (1952, 1959). Using the Panel Study of Income Dynamics (PSID) along with empirically informed estimates of nondiscretionary consumption liabilities, human capital, and financial wealth allocations, we infer household economic balance sheets. We then ask, what would the risk tolerance coefficient need to be to arrive at the empirically observed values? We are able to do this for 18,015 individuals/households, forming a distribution of empirically implied risk tolerance coefficients at different ages. We then use the implied risk tolerance as a basis for evaluating whether households act in a manner consistent with a key assumption of the lifecycle hypothesis; namely, that risk tolerance is constant over the lifecycle. We find support of this hypothesis in the data. Households have a near constant implied risk tolerance based on their balance sheets and varying implied risk tolerances based on financial wealth, increasing early in life and decreasing afterwards.

Sebastian Gomez-Cardona

Director of Research

I am Director of Research in Investment Advice and Planning at Morningstar Retirement.