Working Paper: CEPR ID: DP4914
Authors: John Y. Campbell; Luis M. Viceira
Abstract: Recent research in empirical finance has documented that expected excess returns on bonds and stocks, real interest rates, and risk shift over time in predictable ways. Furthermore, these shifts tend to persist over long periods of time. In this paper we propose an empirical model that is able to capture these complex dynamics, yet is simple to apply in practice, and we explore its implications for asset allocation. Changes in investment opportunities can alter the risk-return tradeoff of bonds, stocks, and cash across investment horizons, thus creating a ?term structure of the risk-return tradeoff?. We show how to extract this term structure from our parsimonious model of return dynamics, and illustrate our approach using data from the US stock and bond markets. We find that asset return predictability has important effects on the variance and correlation structure of returns on stocks, bonds and T-bills across investment horizons.
Keywords: long-horizon investing; mean-variance analysis; risk-return tradeoff; vector autoregression
JEL Codes: G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| expected excess returns on bonds and stocks (G12) | risk-return tradeoff (G11) |
| changes in investment opportunities (G11) | risk-return tradeoff (G11) |
| expected excess returns on bonds and stocks (G12) | expected excess returns on stocks (G17) |
| risk-return tradeoff (G11) | mean-reversion in stock returns (G17) |
| risk-return tradeoff (G11) | volatility (E32) |
| correlation structure of asset returns (C10) | investment horizons (G11) |