Strategic Asset Allocation: Portfolio Choice for Long-Term Investors

By Campbell, John Y. | NBER Reporter, Fall 2000 | Go to article overview

Strategic Asset Allocation: Portfolio Choice for Long-Term Investors


Campbell, John Y., NBER Reporter


John Y. Campbell [*]

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 50 years ago by Harry Markowitz, [1] 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, including 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, along with financial wealth, to support their consumption.

Robert Merton showed 30 years ago that the solution to a long-term portfolio choice problem can be very different from the solution to a short-term problem. [2] In particular, if investment opportunities vary 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 [3] have coined the phrase "strategic asset allocation" to describe this farsighted response to time-varying investment opportunities.

Unfortunately, Merton's intertemporal model is hard to solve. Until recently, solutions to the model were available only in those trivial cases in which 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 minimal influence on financial planners and their clients. This situation has begun to change recently 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. It also sheds new light on important issues of public policy such as the design of the Social Security system.

Who Should Buy Long-Term Bonds?

An important difficulty with mean-variance analysis 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. [4]

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 percent stocks and 20 percent bonds, a conservative investor should maintain the same 4:1 ratio of stocks to bonds at a lower scale, perhaps 40 percent equities and 10 percent bonds, with 50 percent 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 percent equities, 40 percent bonds, and 20 percent cash. Investors and financial planners do not seem to take mean-variance analysis seriously.

Furthermore, it is hard to explain -- using mean-variance analysis -- why any investors hold large positions in bond. Mean-variance analysis treats cash as the riskless asset, and treats bonds merely as another risky asset like stocks. …

The rest of this article is only available to active members of Questia

Already a member? Log in now.

Notes for this article

Add a new note
If you are trying to select text to create highlights or citations, remember that you must now click or tap on the first word, and then click or tap on the last word.
One moment ...
Default project is now your active project.
Project items

Items saved from this article

This article has been saved
Highlights (0)
Some of your highlights are legacy items.

Highlights saved before July 30, 2012 will not be displayed on their respective source pages.

You can easily re-create the highlights by opening the book page or article, selecting the text, and clicking “Highlight.”

Citations (0)
Some of your citations are legacy items.

Any citation created before July 30, 2012 will labeled as a “Cited page.” New citations will be saved as cited passages, pages or articles.

We also added the ability to view new citations from your projects or the book or article where you created them.

Notes (0)
Bookmarks (0)

You have no saved items from this article

Project items include:
  • Saved book/article
  • Highlights
  • Quotes/citations
  • Notes
  • Bookmarks
Notes
Cite this article

Cited article

Style
Citations are available only to our active members.
Buy instant access to cite pages or passages in MLA, APA and Chicago citation styles.

(Einhorn, 1992, p. 25)

(Einhorn 25)

1. Lois J. Einhorn, Abraham Lincoln, the Orator: Penetrating the Lincoln Legend (Westport, CT: Greenwood Press, 1992), 25, http://www.questia.com/read/27419298.

Cited article

Strategic Asset Allocation: Portfolio Choice for Long-Term Investors
Settings

Settings

Typeface
Text size Smaller Larger Reset View mode
Search within

Search within this article

Look up

Look up a word

  • Dictionary
  • Thesaurus
Please submit a word or phrase above.
Print this page

Print this page

Why can't I print more than one page at a time?

Help
Full screen

matching results for page

    Questia reader help

    How to highlight and cite specific passages

    1. Click or tap the first word you want to select.
    2. Click or tap the last word you want to select, and you’ll see everything in between get selected.
    3. You’ll then get a menu of options like creating a highlight or a citation from that passage of text.

    OK, got it!

    Cited passage

    Style
    Citations are available only to our active members.
    Buy instant access to cite pages or passages in MLA, APA and Chicago citation styles.

    "Portraying himself as an honest, ordinary person helped Lincoln identify with his audiences." (Einhorn, 1992, p. 25).

    "Portraying himself as an honest, ordinary person helped Lincoln identify with his audiences." (Einhorn 25)

    "Portraying himself as an honest, ordinary person helped Lincoln identify with his audiences."1

    1. Lois J. Einhorn, Abraham Lincoln, the Orator: Penetrating the Lincoln Legend (Westport, CT: Greenwood Press, 1992), 25, http://www.questia.com/read/27419298.

    Cited passage

    Thanks for trying Questia!

    Please continue trying out our research tools, but please note, full functionality is available only to our active members.

    Your work will be lost once you leave this Web page.

    Buy instant access to save your work.

    Already a member? Log in now.

    Oops!

    An unknown error has occurred. Please click the button below to reload the page. If the problem persists, please try again in a little while.