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Portfolio choice over the lifecycle when the stock and labor markets are cointegrated,
 J. Finance
, 2007
"... StandardNutzungsbedingungen: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden. Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, ..."
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Cited by 60 (1 self)
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StandardNutzungsbedingungen: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden. Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen. Sofern die Verfasser die Dokumente unter OpenContentLizenzen (insbesondere CCLizenzen) zur Verfügung gestellt haben sollten, gelten abweichend von diesen Nutzungsbedingungen die in der dort genannten Lizenz gewährten Nutzungsrechte. The optimal portfolio choice problem over the life cycle has received considerable attention in political, financial, and academic circles. Yet, in spite of the vast work on this topic, there is still much disagreement across empirical observation, conventional wisdom, and the predictions of most of the academic literature. Terms of use: Documents in EconStor may While the level of stock market participation has increased significantly over the decades, several studies report that risky asset holdings have typically been low at young ages, and then either increasing or humpshaped over the life cycle (see, for example, Ameriks and Zeldes Both empirical observation and conventional wisdom seem at odds with the academic literature. First, early academic studies such as In an attempt to reconcile theory and observation, many of the restrictive assumptions underlying the Note, however, that the labor income specification in these models may be unnecessarily restrictive. In particular, if the contemporaneous correlation ρ R M ,L between market returns and changes to aggregate labor income flow is specified to be low (consistent with the data), then these models force longerterm correlations to be low as well. Such specifications also force the correlation ρ R M ,R L between the return to the market portfolio and the return to human capital (which equals the sum of current labor income and the unobservable "capital gain" to human capital) to be low. In contrast to these papers, we specify aggregate labor income to be cointegrated with dividends. 3 Such a specification is consistent with empirically observed low contemporaneous correlations ρ R M ,L between market returns and changes to aggregate labor income flow. However, this specification permits correlations between returns to human capital and market returns to be significantly higher. The notion that returns to human capital and market returns should be highly correlated is not new. For example, Baxter and Jerman (1997, BJ) test for the existence of cointegration by using data on aggregate employee compensation and GDP growth (in contrast to using dividends on the market portfolio, as we do in this paper). Although they only find weak statistical evidence in support of cointegration, as is often the case in tests of cointegration, they proceed under the economically plausible assumption that such a relation exists and investigate the implications for international portfolio choice. Assuming a constant discount rate, they find that the present values of capital income and labor income exhibit a high correlation, in excess of 90%. Using a very different argument, Campbell (1996) also reports a high correlation between human capital and market returns. In particular, he assumes that labor income follows an AR(1) process and has low contemporaneous correlation with stock dividends. However, he assumes that the same (highly timevarying) discount factor should be used to discount both labor income 2 Several other contributions investigate the implications of human capital for asset pricing and portfolio choice. (1996) and Lucas (1994) study the equity premium in economies with aggregate and idiosyncratic labor income shocks, transaction costs, as well as borrowing and shortsales constraints.
Portfolio choice problems
 Handbook of Financial Econometrics, forthcoming
, 2004
"... After years of relative neglect in academic circles, portfolio choice problems are again at the forefront of financial research. The economic theory underlying an investor’s optimal ..."
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Cited by 52 (3 self)
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After years of relative neglect in academic circles, portfolio choice problems are again at the forefront of financial research. The economic theory underlying an investor’s optimal
Dynamic Portfolio Selection by Augmenting the Asset Space
 THE JOURNAL OF FINANCE • VOL. LXI, NO. 5 • OCTOBER 2006
, 2006
"... We present a novel approach to dynamic portfolio selection that is as easy to implement as the static Markowitz paradigm. We expand the set of assets to include mechanically managed portfolios and optimize statically in this extended asset space. We consider “conditional” portfolios, which invest in ..."
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Cited by 46 (8 self)
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We present a novel approach to dynamic portfolio selection that is as easy to implement as the static Markowitz paradigm. We expand the set of assets to include mechanically managed portfolios and optimize statically in this extended asset space. We consider “conditional” portfolios, which invest in each asset an amount proportional to conditioning variables, and “timing” portfolios, which invest in each asset for a single period and in the riskfree asset for all other periods. The static choice of these managed portfolios represents a dynamic strategy that closely approximates the optimal dynamic strategy for horizons up to 5 years.
The term structure of the riskreturn tradeoff
 Financial Analysts Journal
, 2005
"... Recent research in empirical finance has documented that expected excess returns on bonds and stocks, real interest rates, and risk shift over time in predictable ways. Furthermore, these shifts tend to persist over long periods of time. This paper has two objectives. First, we propose an empirical ..."
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Cited by 34 (5 self)
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Recent research in empirical finance has documented that expected excess returns on bonds and stocks, real interest rates, and risk shift over time in predictable ways. Furthermore, these shifts tend to persist over long periods of time. This paper has two objectives. First, we propose an empirical model that is able to capture the complex dynamics of expected returns and risk, yet is simple to apply in practice. Second, we explore the implications for asset allocation. Changes in investment opportunities have the important implication that the riskreturn tradeoff of bonds, stocks, and cash may be significantly different across investment horizons, thus creating a “term structure of the riskreturn tradeoff. ” We show how one can easily extract this term structure using our parsimonious model of return dynamics, and illustrate our approach using data from the U.S. stock and bond markets. We find that asset return predictability has important effects on the variance and correlation structure of returns on stocks, bonds and Tbills across investment horizons. Recent research in empirical finance has documented that expected excess returns on bonds and stocks, real interest rates, and risk shift over time in predictable ways. Furthermore, these shifts tend to persist over long periods of time. Starting at least
Dynamic meanvariance asset allocation
 Working Paper, London Business School
, 2007
"... Toronto and University of Warwick for helpful comments. All errors are our responsibility. ..."
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Cited by 32 (1 self)
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Toronto and University of Warwick for helpful comments. All errors are our responsibility.
Predictable returns and asset allocation: Should a skeptical investor time the market
 Journal of Econometrics
, 2009
"... are grateful for financial support from the Aronson+Johnson+Ortiz fellowship through the Rodney L. White Center for Financial Research. This manuscript does not reflect the views of the Board of Governors of the Federal Reserve System. Predictable returns and asset allocation: Should a skeptical inv ..."
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Cited by 28 (0 self)
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are grateful for financial support from the Aronson+Johnson+Ortiz fellowship through the Rodney L. White Center for Financial Research. This manuscript does not reflect the views of the Board of Governors of the Federal Reserve System. Predictable returns and asset allocation: Should a skeptical investor time the market? We investigate optimal portfolio choice for an investor who is skeptical about the degree to which excess returns are predictable. Skepticism is modeled as an informative prior over the R 2 of the predictive regression. We find that the evidence is sufficient to convince even an investor with a highly skeptical prior to vary his portfolio on the basis of the dividendprice ratio and the yield spread. The resulting weights are less volatile and deliver superior outofsample performance as compared to the weights implied by an entirely modelbased Are excess returns predictable, and if so, what does this mean for investors? In classic studies of rational valuation (e.g. Samuelson (1965, 1973), Shiller (1981)), risk premia are constant over time and thus excess returns are unpredictable. 1
2009, `Dynamic Asset Allocation with Ambiguous Return Predictability'. Working Paper
"... Abstract We study an investor's optimal consumption and portfolio choice problem when he confronts with two possibly misspecified submodels of stock returns: one with IID returns and the other with predictability. We adopt a generalized recursive ambiguity model to accommodate the investor&apo ..."
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Cited by 23 (3 self)
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Abstract We study an investor's optimal consumption and portfolio choice problem when he confronts with two possibly misspecified submodels of stock returns: one with IID returns and the other with predictability. We adopt a generalized recursive ambiguity model to accommodate the investor's aversion to model uncertainty. The investor deals with specification doubts by slanting his beliefs about submodels of returns pessimistically, causing his investment strategy to be more conservative than the Bayesian strategy. This effect is large for extreme values of the predictive variable. Unlike in the Bayesian framework, model uncertainty induces a hedging demand, which may cause the investor to decrease his stock allocations sharply and then increase with his prior probability of IID returns. Adopting suboptimal investment strategies by ignoring model uncertainty can lead to sizable welfare costs.
Strategic asset allocation and consumption decision under multivariate regime switching, Working Paper 20052B, Federal Reserve of St. Louis
, 2005
"... This paper studies strategic asset allocation and consumption choice in the presence of regime switching in asset returns. We find evidence that four separate regimes characterized as crash, slow growth, bull and recovery states are required to capture the joint distribution of stock and bond retu ..."
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Cited by 17 (3 self)
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This paper studies strategic asset allocation and consumption choice in the presence of regime switching in asset returns. We find evidence that four separate regimes characterized as crash, slow growth, bull and recovery states are required to capture the joint distribution of stock and bond returns. Optimal asset allocations vary considerably across these states both among bonds and stocks and among large and small stocks and change over time as investors revise their estimates of the underlying state probabilities. In the crash state investors always allocate more of their portfolio to stocks the longer their investment horizon, while the optimal allocation to stocks declines as a function of the investment horizon in bull markets. The joint effects of learning about the underlying state probabilities and predictability of asset returns from the dividend yield give rise to a nonmonotonic relationship between the investment horizon and the demand for stocks. Consumptiontowealth ratios are found to depend on the underlying state and welfare costs from ignoring regime switching are substantial even after accounting for parameter uncertainty. Outofsample forecasting experiments confirmtheeconomicimportanceof accounting for the presence of regimes in asset returns. We are grateful to John Campbell for discussion and also thank seminar participants at Caltech, the Innovations in Financial
Sequential learning, predictive regressions, and optimal portfolio returns, working paper
, 2009
"... This paper develops particle filtering and learning for sequential inference in empirical asset pricing models. We provide a computationally feasible toolset for sequential parameter learning, hypothesis testing, and model monitoring, incorporating multiple observable variables, unobserved stocha ..."
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Cited by 8 (1 self)
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This paper develops particle filtering and learning for sequential inference in empirical asset pricing models. We provide a computationally feasible toolset for sequential parameter learning, hypothesis testing, and model monitoring, incorporating multiple observable variables, unobserved stochastic volatility, and unobserved “drifting ” regression coefficients. Sequential inference allows us to observe how the views of economic decision makers evolve in real time. Empirically, we analyze time series predictability of equity returns, using both the traditional dividend yield and net payout yield, which incorporates issuances and repurchases. We find that the data rejects the traditional model for both predictors, in favor of models with drifting coefficients or stochastic volatility. We study the optimal portfolio allocation problem under parameter, state variable, and model uncertainty, and show that the Bayesian portfolios are more stable and have better outofsample performance than rolling regressions.