Strategic Asset Allocation:
Portfolio Choice
John Y. Campbell, Harvard University
Academic finance has had a remarkable impact on many financial services. Yet financial planners offering portfolio advice to long-term investors have received curiously little guidance from academic financial economists.
Mean-variance analysis, developed almost fifty years ago by Harry Markowitz, has provided a basic paradigm for portfolio choice. This approach usefully emphasizes the ability of diversification to reduce risk, but it ignores several critically important factors. Most notably, the analysis is static; it assumes that investors care only about risks to wealth one period ahead. However many investors – both individuals and institutions such as charitable foundations or universities – seek to finance a stream of consumption over a long lifetime. In addition, mean variance analysis treats financial wealth in isolation from income. Long-term investors typically receive a stream of income and use it, long with financial wealth, to support their consumption.
Robert Merton showed thirty years ago that the solution to a long-term portfolio choice problem can be very different from the solution to a short-term problem. In particular, if investment opportunities are varying over time, then long-term investors care about shocks to investment opportunities – the productivity of wealth – as well as shocks to wealth itself. They may seek to hedge their exposures to wealth productivity shocks, and this gives rise to intertemporal hedging demands for financial assets. Michael Brennan, Eduardo Schwartz, and Ronald Lagnado have coined the phrase strategic asset allocation to describe this far-sighted response to time-varying investment opportunities.
Unfortunately Merton's intertemporal model is hard to solve. Until recently solutions to the model were only available in those trivial cases where it reduces to the static model. Therefore the Merton model has not become a usable empirical paradigm, has not displaced the Markowitz model, and has had only limited influence on financial planners and their clients. Recently this situation has begun to change as a result of advances in both analytical and numerical methods. A new empirical paradigm is emerging. Interestingly, this paradigm both supports and qualifies traditional rules of thumb used by financial planners.
The contrast between mean-variance analysis and financial planning advice becomes clear when one considers the classic problem of allocating a portfolio among three broad asset classes: stocks, bonds, and money market funds (cash). One of the most famous results in mean-variance analysis is James Tobin’s mutual fund theorem of portfolio choice, according to which all investors should combine cash with a single portfolio or mutual fund of risky assets.
The mutual fund theorem directs all investors, conservative or aggressive, to hold the same portfolio of stocks and bonds, mixing the portfolio with more or less cash depending on the investor’s aversion to risk. Thus if an aggressive investor holds 80% stocks and 20% bonds, a conservative investor should maintain the same 4:1 ratio of stocks
to bonds at a lower scale, perhaps 40% equities and 10% bonds, with 50% of the portfolio in cash. This is quite
different from the way conservative investors actually behave, and are advised to behave by financial planners.
In practice, conservative investors favor bonds relative to equities so that a conservative portfolio might consist of
40% equities, 40% bonds, and 20% cash. Investors and financial planners do not seem to take mean-variance
analysis seriously.
An intertemporal analysis treats bonds very differently. For long-term investors, money market investments are not riskless because they must be rolled over at uncertain future real interest rates. Just as borrowers have come to appreciate that short-term debt carries a risk of having to refinance at high rates during a financial crisis, so long-term investors must appreciate that short-term investments carry the risk of having to reinvest at low rates in the future. For long-term investors, inflation-indexed bonds are actually less risky than cash. These bonds do not have a stable market value in the short term, but they deliver a predictable stream of real income and thus support a stable standard of living in the long term. In environments where inflation uncertainty is low, nominal bonds behave like inflation-indexed bonds and are acceptable substitutes for them in the portfolios of conservative investors. When inflation uncertainty is high, however, the conventional advice of financial planners applies only to inflation-indexed bonds.
Luis Viceira considers this and many other issues that arise when one tries to implement the intertemporal approach to portfolio choice. The book emphasizes loglinear approximation methods that deliver simple, readily interpretable approximate solutions to long-term portfolio choice problems. It presents illustrative solutions using parameters estimated from historical data.
The book explores several factors that may lead long-term investors to choose different portfolio strategies from short-term investors, including changing real interest rates, mean-reversion in stock returns, and labor income. These factors, and other empirically relevant considerations such as taxation, have not yet been integrated in a single empirically usable model. However the construction of such a model is now a realistic ambition. This offers the exciting prospect that financial economists will at last be able to offer relevant and scientifically grounded investment advice.
Clarendon Lectures in Economics
256 pages January 2002
0-19-829694-0 £20.00 Hardback
