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Portfolio Choice under Inflation: Are Popular Recommendations Consistent with Rational Behavior?

  • Munk, Claus

    (University of Southern Denmark)

  • Sørensen, Carsten

    (Department of Finance, Copenhagen Business School)

  • Vinther, Tina Nygaard

    (SimCorp Danmark A/S)

We consider the optimal asset allocation choice of an investor who can invest in cash (a money market bank account), nominal bonds, and stocks (the stock index). The investor faces an incomplete market setting and is not able to perfectly hedge long run real interest rate risk using the available securities. The optimal invest- ment strategy is consistent with the following features of popular investment advice which have been pointed out as puzzles: (i) a decreasing fraction of stocks in the portfolio as time passes towards the investment horizon, and (ii) a higher bond to stock ratio for more conservative (less risk tolerant) investors (Canner, Mankiw and Weil, 1997). The model for asset price dynamics is calibrated to US market data and, furthermore, risk aversion parameters and time horizons are calibrated so as to obtain a match between the optimal asset allocations and observed investment recommendations for \aggressive," \moderate," and \conservative" investor groups with di®erent investment horizons.

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File URL: http://openarchive.cbs.dk/cbsweb/handle/10398/7170
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Paper provided by Copenhagen Business School, Department of Finance in its series Working Papers with number 2001-6.

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Length: 23 pages
Date of creation: 01 Dec 2001
Date of revision:
Handle: RePEc:hhs:cbsfin:2001_006
Contact details of provider: Postal: Department of Finance, Copenhagen Business School, Solbjerg Plads 3, A5, DK-2000 Frederiksberg, Denmark
Phone: +45 3815 3815
Web page: http://www.cbs.dk/departments/finance/
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  1. R. C. Merton, 1970. "Optimum Consumption and Portfolio Rules in a Continuous-time Model," Working papers 58, Massachusetts Institute of Technology (MIT), Department of Economics.
  2. Ingersoll, Jonathan E. & Skelton, Jeffrey & Weil, Roman L., 1978. "Duration Forty Years Later," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 13(04), pages 627-650, November.
  3. Niko Canner & N. Gregory Mankiw & David N. Weil, 1994. "An Asset Allocation Puzzle," NBER Working Papers 4857, National Bureau of Economic Research, Inc.
  4. Viceira, Luis & Campbell, John, 2001. "Who Should Buy Long-Term Bonds?," Scholarly Articles 3128709, Harvard University Department of Economics.
  5. Merton, Robert C, 1969. "Lifetime Portfolio Selection under Uncertainty: The Continuous-Time Case," The Review of Economics and Statistics, MIT Press, vol. 51(3), pages 247-57, August.
  6. Elton, Edwin J. & Gruber, Martin J., 2000. "The Rationality of Asset Allocation Recommendations," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 35(01), pages 27-41, March.
  7. Pennacchi, George G, 1991. "Identifying the Dynamics of Real Interest Rates and Inflation: Evidence Using Survey Data," Review of Financial Studies, Society for Financial Studies, vol. 4(1), pages 53-86.
  8. Merton, Robert C, 1973. "An Intertemporal Capital Asset Pricing Model," Econometrica, Econometric Society, vol. 41(5), pages 867-87, September.
  9. Cox, John C. & Huang, Chi-fu, 1991. "A variational problem arising in financial economics," Journal of Mathematical Economics, Elsevier, vol. 20(5), pages 465-487.
  10. Cox, John C & Ingersoll, Jonathan E, Jr & Ross, Stephen A, 1979. "Duration and the Measurement of Basis Risk," The Journal of Business, University of Chicago Press, vol. 52(1), pages 51-61, January.
  11. Breeden, Douglas T., 1986. "Consumption, production, inflation and interest rates : A synthesis," Journal of Financial Economics, Elsevier, vol. 16(1), pages 3-39, May.
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