Publication: Long-term optimal portfolio allocation under dynamic horizon-specific risk aversion
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2016-09-01
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Abstract
This paper studies the long-term asset allocation problem of an individual with risk aversion
coefficient that i) varies with economic conditions, and ii) exhibits different risk attitudes
towards the short and the long term. To do this, we propose a parametric linear portfolio
policy that accommodates an arbitrarily large number of assets in the portfolio and a
piecewise linear risk aversion coefficient. These specifications of the optimal portfolio policy
and individual's risk aversion allow us to apply GMM methods for parameter estimation and
testing. Our empirical results provide statistical evidence of the existence of a short-term and
a long-term regime in the individual's risk aversion. Long-term risk aversion is always higher
than short-term risk aversion, and it is more statistically significant as the investment horizon
increases. The analysis of the optimal portfolio weights also suggests that the allocation to
stocks and bonds is strongly negatively correlated, with the magnitude of the portfolio weights
and risk aversion coefficients increasing as the investment horizon expands.
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Dynamic risk aversion, Threshold nonlinearity tests, Intertemporal portfolio theory, Parametric portfolio policies