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Consumption and Portfolio Decisions When Expected Returns are Time Varying

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  • Campbell, John
  • Viceira, Luis

Abstract

This paper presents an approximate analytical solution to the optimal consumption and portfolio choice problem of an infinitely lived investor with Epstein-Zin-Weil utility who faces a constant riskless interest rate and a time-varying equity premium. When the model is calibrated to U. S. stock market data, it implies that intertemporal hedging motives greatly increase, and may even double, the average demand for stocks by investors whose risk-aversion coefficients exceed one. The optimal portfolio policy also involves timing the stock market. Failure to time or to hedge can cause large welfare losses relative to the optimal policy.

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File URL: http://dash.harvard.edu/bitstream/handle/1/3163266/campbell_consumption.pdf
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Bibliographic Info

Paper provided by Harvard University Department of Economics in its series Scholarly Articles with number 3163266.

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Date of creation: 1999
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Publication status: Published in Quarterly Journal of Economics
Handle: RePEc:hrv:faseco:3163266

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  1. Campbell, John Y., 1987. "Stock returns and the term structure," Journal of Financial Economics, Elsevier, vol. 18(2), pages 373-399, June.
  2. Phillippe Weil, 1997. "The Equity Premium Puzzle and the Risk-Free Rate Puzzle," Levine's Working Paper Archive 1833, David K. Levine.
  3. LuisM. Viceira & John Y. Campbell, 2001. "Who Should Buy Long-Term Bonds?," American Economic Review, American Economic Association, vol. 91(1), pages 99-127, March.
  4. John Y. Campbell & Luis M. Viceira, 1999. "Consumption And Portfolio Decisions When Expected Returns Are Time Varying," The Quarterly Journal of Economics, MIT Press, vol. 114(2), pages 433-495, May.
  5. Cox, John C. & Huang, Chi-fu, 1989. "Optimal consumption and portfolio policies when asset prices follow a diffusion process," Journal of Economic Theory, Elsevier, vol. 49(1), pages 33-83, October.
  6. Fama, Eugene F. & French, Kenneth R., 1988. "Dividend yields and expected stock returns," Journal of Financial Economics, Elsevier, vol. 22(1), pages 3-25, October.
  7. Brennan, Michael J. & Schwartz, Eduardo S. & Lagnado, Ronald, 1997. "Strategic asset allocation," Journal of Economic Dynamics and Control, Elsevier, vol. 21(8-9), pages 1377-1403, June.
  8. Alberto Giovannini & Philippe Weil, 1989. "Risk Aversion and Intertemporal Substitution in the Capital Asset Pricing Model," NBER Working Papers 2824, National Bureau of Economic Research, Inc.
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