Human capital investment and portfolio choice over the life-cycle∗ Preliminary and incomplete

I develop a model of life-cycle portfolio choice with non-tradeable idiosyncratic labor income where the agent has an option to invest in human capital, for example through education. The inability to borrow against her human capital depresses the agent’s demand for equity, as she is concerned about being liquidity constrained when it is optimal to invest. The model has many predictions that are broadly consistent with the standard financial advice for people saving towards a target such as education. Specifically, wealthy agents display a hump-shaped pattern of lifetime risky asset holdings, as the young are more likely to exercise the option than the old. In contrast, the option generates local risk seeking behavior among less wealthy agents, who then show a declining risky asset profile over the life time, as their option is either exercised or becomes worthless. Finally, the model generates realistic life cycle labor income profiles jointly with the endogenous levels of educational attainment. Allowing for financial aid, which relaxes the borrowing constraint, does not produce a strong mitigating effect on the demand for liquidity as long as the agent has to forgo her labor income earnings while in school. This opportunity cost creates a liquidity demand that is akin to precautionary saving. Optimal investment rule depends on the marginal product of labor and therefore varies over the business cycle. This induces cyclical variation in the demand for liquidity, suggesting potential implications for asset pricing. JEL Classification: G11, D91, D14.