On the E¤ects of Individual Labor- ‡exibility on Rational Portfolio Allocation: Making a Case for Businessman Risk and Employer Stock Ownership

This paper studies the impact of labor ‡exibility on optimal life-cycle portfolio decisions, particularly the ability to change industries or …rms within industries. The model addresses two frequently observed portfolio behaviors that are seemingly inconsistent with rational portfolio choice. The …rst is the tendency of workers and entrepreneurs to hold their company’s stock. The second is the propensity of workers to limit their equity holdings through time. The explanation o¤ered here for both of these behaviors lies in the option to switch jobs when one’s company does poorly. This is equivalent to holding put options on one’s own company stock and call options in the other company’s stock, where both options must be exercised at the same time. Given these initial undiversi…ed implicit …nancial holdings, workers need to allocate a relatively large share of their regular …nancial assets to their own company’s stock and a relatively small share to the stock of their alternative employment simply to restore overall portfolio balance. I consider the case of an option to switch between a relative safe and a relatively risky job. I …nd that when workers start their career in the safer job, they optimally hold a positive amount in their company’s stock (under some conditions almost half of their …nancial wealth). However, if workers start out in the riskier job, they short their company’s stock –just as in the absence of job-switching options –but they short less. I am very grateful to J. Detemple, F. Gourio, R. Merton, Z. Bodie and L. Kotliko¤ for many discussions and helpful suggestions. I also thank S. Basu, P. Ireland, R. King, K. Lang, M. Manove, D. Mookherjee, A. Verdelhan, and conference participants at Boston University’s Department of Economics and School of Management, and at the Fall 2007 Boston University-Boston College Green Line Macroeconomics Meeting, for their numerous useful comments. yDoriana Ru¢ no, Boston University Department of Economics, 270 Bay State Road, Boston, MA 02215, U.S.A. Phone: (617) 447 9987 and Email: [email protected]