License to Spend : Consumption-Income Sensitivity and Portfolio Choice ∗

Contrary to the predictions of traditional life-cycle models, households do not engage in perfect consumption smoothing. Instead, consumption tracks current income. Similarly, weak evidence of income hedging runs against standard portfolio theory. We link these two puzzles by proposing a model in which current income is an entitlement to consume, or a license to spend. License-to-spend investors feel more entitled to consume as income rises and do not perfectly smooth consumption. Therefore, they are also less interested in the income hedging potential of financial assets. We test the license-to-spend model using data from the Panel Study of Income Dynamics and find that households whose consumption tracks current income also exhibit a weakened income hedging motive in their portfolio decisions. Overall, we show that the absence of income hedging is the portfolio choice analogue of imperfect consumption smoothing. JEL classification: D11, D12, D14, G11. ∗Please address all correspondence to George Korniotis, Department of Finance, School of Business Administration, University of Miami, 514 Jenkins Building, Coral Gables, FL 33124; Phone: 305-284-5728; email: gkorniotis@miami.edu. Jawad Addoum can be reached at 305284-8286 or jawad.addoum@miami.edu. Stefanos Delikouras can be reached at 305-284-1864 or sdelikouras@bus.miami.edu. We thank Sandro Andrade, Tim Burch, Vidhi Chhaochharia, George Constantinides, Doug Emery, Alok Kumar, Alex Michaelides, Stephan Siegel, Stijn Van Nieuwerburgh, and Luis Viceira for helpful comments and valuable suggestions. We are responsible for all remaining errors and omissions. License to Spend: Consumption-Income Sensitivity and Portfolio Choice Abstract – Contrary to the predictions of traditional life-cycle models, households do not engage in perfect consumption smoothing. Instead, consumption tracks current income. Similarly, weak evidence of income hedging runs against standard portfolio theory. We link these two puzzles by proposing a model in which current income is an entitlement to consume, or a license to spend. License-to-spend investors feel more entitled to consume as income rises and do not perfectly smooth consumption. Therefore, they are also less interested in the income hedging potential of financial assets. We test the license-to-spend model using data from the Panel Study of Income Dynamics and find that households whose consumption tracks current income also exhibit a weakened income hedging motive in their portfolio decisions. Overall, we show that the absence of income hedging is the portfolio choice analogue of imperfect consumption smoothing. Contrary to the predictions of traditional life-cycle models, households do not engage in perfect consumption smoothing. Instead, consumption tracks current income. Similarly, weak evidence of income hedging runs against standard portfolio theory. We link these two puzzles by proposing a model in which current income is an entitlement to consume, or a license to spend. License-to-spend investors feel more entitled to consume as income rises and do not perfectly smooth consumption. Therefore, they are also less interested in the income hedging potential of financial assets. We test the license-to-spend model using data from the Panel Study of Income Dynamics and find that households whose consumption tracks current income also exhibit a weakened income hedging motive in their portfolio decisions. Overall, we show that the absence of income hedging is the portfolio choice analogue of imperfect consumption smoothing. JEL classification: D11, D12, D14, G11.