Working Papers,
Copenhagen Business School, Department of Finance

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

JEL-codes: G00; G10; G30

23 pages, December 1, 2001

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