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Consumption and Portfolio Decisions When Expected Returns Are Time Varying

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  • John Y. Campbell
  • Luis M. Viceira

Abstract

This paper proposes and implements a new approach to a classic unsolved problem in financial economics: the optimal consumption and portfolio choice problem of a long-lived investor facing time-varying investment opportunities. The investor is assumed to be infinitely lived, to have recursive Epstein-Zin-Weil utility, and to choose in discrete time between a riskless asset with a constant return, and a risky asset with constant return variance whose expected log return follows an AR(1) process. The paper approximates the choice problem by log-linearizing the budget constraint and Euler equations, and derives an analytical solution to the approximate problem. When the model is calibrated to US stock market data it implies that intertemporal hedging motives greatly increase, and may even double, the average demand for stocks by long-lived 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.

Suggested Citation

  • John Y. Campbell & Luis M. Viceira, 1998. "Consumption and Portfolio Decisions When Expected Returns Are Time Varying," Harvard Institute of Economic Research Working Papers 1835, Harvard - Institute of Economic Research.
  • Handle: RePEc:fth:harver:1835
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    References listed on IDEAS

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    1. Mehra, Rajnish & Prescott, Edward C., 1985. "The equity premium: A puzzle," Journal of Monetary Economics, Elsevier, vol. 15(2), pages 145-161, March.
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    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. John Y. Campbell & Luis M. Viceira, 1999. "Consumption and Portfolio Decisions when Expected Returns are Time Varying," The Quarterly Journal of Economics, Oxford University Press, vol. 114(2), pages 433-495.
    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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    More about this item

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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