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

We consider the optimal asset allocation choice of an investorwho 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 investment 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 (lessrisk 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 quot;aggressive,quot; quot;moderate,quot; and quot;conservativequot; investor groups with different investment horizons