In this book I will usually be modeling risk and return at the collective scale or at the cohort one. A cohort means the set of all same-aged individuals. It turns out that the ratio of females to males tends to rise with each older cohort, for reasons Bob Trivers explains, as does wealth up to a point. But in cohort analysis, both effects (wealth and sex ratio) are incorporated into effects of cohort age. That will simplify
modeling.
My risk theory is another example of what looks to be surprise and novelty until shown otherwise. The unusual idea lies in projecting the owner’s time preference/return rate onto the asset rather than conversely. Thus all the owner’s assets of both factors are selected or modified to fit her current risk profile. This would count her liquid securities portfolio, cap weighted, as a single asset. All other assets are too illiquid for practical rebalancing. We own the assets best suited to our risk profiles, if for no better reason than that we wouldn’t be the winning bidders for any others if we wanted them. As our risk profiles evolve with age, we modify or trade them. We will tend to have anticipated this need, and to have factored modification or trading costs into our bid price. It turns out that this interpretation
can simplify the math of present value and present cost.
It helps in supporting the pay rule, and explaining age-wage profiles, by rebutting a hypothesis, sometimes argued, that productivity of human capital might rise with age. Productivity, rate of return and time preference rate all mean the same. My risk theory argues that we knowa cohort’s risk tolerance from the return to its cap- weighted securities portfolio as a whole. All other assets of the same cohort, including human capital, will tend to agree with it in return. Return to security portfolios tends to be transparent. It declines with adult cohort age. | infer that
return to human capital does the same.
My risk theory and depreciation theory together add a finishing touch to the pay rule. The key supporting evidence is age-wage profiles. Depreciation theory offers
solid logic, in the face of apparent contrary data, that pay is all human depreciation
Chapter 2: Fast Forward 1/06/16 27
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