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Long-term optimal portfolio allocation under dynamic horizon-specific risk aversion

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  • Olmo, José
  • Gonzalo, Jesús

Abstract

This paper studies the long-term asset allocation problem of an individual with risk aversion coefficient that i) varies with economic conditions, and ii) exhibits different risk attitudes towards the short and the long term. To do this, we propose a parametric linear portfolio policy that accommodates an arbitrarily large number of assets in the portfolio and a piecewise linear risk aversion coefficient. These specifications of the optimal portfolio policy and individual's risk aversion allow us to apply GMM methods for parameter estimation and testing. Our empirical results provide statistical evidence of the existence of a short-term and a long-term regime in the individual's risk aversion. Long-term risk aversion is always higher than short-term risk aversion, and it is more statistically significant as the investment horizon increases. The analysis of the optimal portfolio weights also suggests that the allocation to stocks and bonds is strongly negatively correlated, with the magnitude of the portfolio weights and risk aversion coefficients increasing as the investment horizon expands.

Suggested Citation

  • Olmo, José & Gonzalo, Jesús, 2016. "Long-term optimal portfolio allocation under dynamic horizon-specific risk aversion," UC3M Working papers. Economics 23599, Universidad Carlos III de Madrid. Departamento de Economía.
  • Handle: RePEc:cte:werepe:23599
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    References listed on IDEAS

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    More about this item

    Keywords

    Intertemporal portfolio theory;

    JEL classification:

    • E62 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Fiscal Policy
    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy

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