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Department of Finance, Copenhagen Business School Working Paper Series, Department of Finance, Copenhagen Business School

No 2001-6:
Portfolio Choice under Inflation: Are Popular Recommendations Consistent with Rational Behavior?

Claus Munk, Carsten Sørensen and Tina Nygaard Vinther

Abstract: We consider the optimal asset allocation choice of an investor who can invest in

cash (a money market bank account), nominal bonds, and stocks (the stock index).

The investor faces an incomplete market setting and is not able to perfectly hedge

long run real interest rate risk using the available securities. The optimal invest-

ment strategy is consistent with the following features of popular investment advice

which have been pointed out as puzzles: (i) a decreasing fraction of stocks in the

portfolio as time passes towards the investment horizon, and (ii) a higher bond to

stock ratio for more conservative (less risk tolerant) investors (Canner, Mankiw and

Weil, 1997). The model for asset price dynamics is calibrated to US market data

and, furthermore, risk aversion parameters and time horizons are calibrated so as

to obtain a match between the optimal asset allocations and observed investment

recommendations for \aggressive," \moderate," and \conservative" investor groups

with di®erent investment horizons.

Keywords: Investment; Nominal bonds; Stocks; Market setting; Securities; Investment strategy; Risk; (follow links to similar papers)

JEL-Codes: G00; G10; G30; (follow links to similar papers)

23 pages, December 1, 2001

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