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Portfolio Advice for a Multifactor World

  • John H. Cochrane

Asset returns, it turns out, do not follow the Capital Asset Pricing Model, and are somewhat predictable over time. I survey and interpret the large body of recent work that adapts traditional portfolio theory to answer, what should an investor do about these new facts in finance? I survey the extension of the famous 2 - fund' theorem to an N-fund'' theorem in which investors either hedge or assume the additional, non-market, sources of priced risk; I survey the burgeoning literature on time-varying portfolio rules and the Bayesian literature that advocates a great deal of caution. In a survey, I emphasize the risk-sharing nature of asset markets, I note the likelihood that many supposed anomalies will not last, and I emphasize the fact that the average investor must hold the market so portfolio decisions must be driven by differences between an investor and the average investor.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 7170.

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Date of creation: Jun 1999
Date of revision:
Publication status: published as Economic Perspectives, Federal Reserve Bank of Chicago, Vol. 23, no. 3(1999): 59-78.
Handle: RePEc:nbr:nberwo:7170
Note: AP EFG
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  1. John Y. Campbell & John H. Cochrane, 1994. "By force of habit: a consumption-based explanation of aggregate stock market behavior," Working Papers 94-17, Federal Reserve Bank of Philadelphia.
  2. Shmuel Kandel & Robert F. Stambaugh, 1995. "On the Predictability of Stock Returns: An Asset-Allocation Perspective," NBER Working Papers 4997, National Bureau of Economic Research, Inc.
  3. 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.
  4. Josef Lakonishok & Robert W. Vishny & Andrei Shleifer, 1993. "Contrarian Investment, Extrapolation, and Risk," NBER Working Papers 4360, National Bureau of Economic Research, Inc.
  5. John H. Cochrane, 1998. "Where is the Market Going? Uncertain Facts and Novel Theories," NBER Working Papers 6207, National Bureau of Economic Research, Inc.
  6. Kent Daniel & David Hirshleifer & Avanidhar Subrahmanyam, 1998. "Investor Psychology and Security Market Under- and Overreactions," Journal of Finance, American Finance Association, vol. 53(6), pages 1839-1885, December.
  7. John Y. CAMPBELL & Luis VICEIRA, 1998. "Who Should Buy Long-Term Bonds?," FAME Research Paper Series rp5, International Center for Financial Asset Management and Engineering.
  8. Fama, Eugene F. & French, Kenneth R., 1993. "Common risk factors in the returns on stocks and bonds," Journal of Financial Economics, Elsevier, vol. 33(1), pages 3-56, February.
  9. John Y. Campbell & John Cochrane, 1999. "Force of Habit: A Consumption-Based Explanation of Aggregate Stock Market Behavior," Journal of Political Economy, University of Chicago Press, vol. 107(2), pages 205-251, April.
  10. 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.
  11. Michael W. Brandt, 1999. "Estimating Portfolio and Consumption Choice: A Conditional Euler Equations Approach," Journal of Finance, American Finance Association, vol. 54(5), pages 1609-1645, October.
  12. Samuelson, Paul A, 1969. "Lifetime Portfolio Selection by Dynamic Stochastic Programming," The Review of Economics and Statistics, MIT Press, vol. 51(3), pages 239-46, August.
  13. 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.
  14. Gallant, A. Ronald & Hansen, Lars Peter & Tauchen, George, 1990. "Using conditional moments of asset payoffs to infer the volatility of intertemporal marginal rates of substitution," Journal of Econometrics, Elsevier, vol. 45(1-2), pages 141-179.
  15. 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.
  16. Kim, Tong Suk & Omberg, Edward, 1996. "Dynamic Nonmyopic Portfolio Behavior," Review of Financial Studies, Society for Financial Studies, vol. 9(1), pages 141-61.
  17. Cochrane, John H. & Sbordone, Argia M., 1988. "Multivariate estimates of the permanent components of GNP and stock prices," Journal of Economic Dynamics and Control, Elsevier, vol. 12(2-3), pages 255-296.
  18. Merton, Robert C, 1973. "An Intertemporal Capital Asset Pricing Model," Econometrica, Econometric Society, vol. 41(5), pages 867-87, September.
  19. Fama, Eugene F. & French, Kenneth R., 1989. "Business conditions and expected returns on stocks and bonds," Journal of Financial Economics, Elsevier, vol. 25(1), pages 23-49, November.
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