Portfolio Choice under Inflation: Are Popular Recommendations Consistent with Rational Behavior?

We consider the optimal asset allocation choice of an investor who can invest in <p> cash (a money market bank account), nominal bonds, and stocks (the stock index). <p> The investor faces an incomplete market setting and is not able to perfectly hedge <p> long run real interest rate risk using the available securities. The optimal invest- <p> ment strategy is consistent with the following features of popular investment advice <p> which have been pointed out as puzzles: (i) a decreasing fraction of stocks in the <p> portfolio as time passes towards the investment horizon, and (ii) a higher bond to <p> stock ratio for more conservative (less risk tolerant) investors (Canner, Mankiw and <p> Weil, 1997). The model for asset price dynamics is calibrated to US market data <p> and, furthermore, risk aversion parameters and time horizons are calibrated so as <p> to obtain a match between the optimal asset allocations and observed investment <p> recommendations for \aggressive," \moderate," and \conservative" investor groups <p> with di®erent investment horizons.