Working Paper: NBER ID: w11119
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 U.S. 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: Risk-return tradeoff; Asset allocation; Investment horizons; Predictability; Vector autoregressive model
JEL Codes: G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| expected returns (G17) | risk-return tradeoff (G11) |
| investment opportunities (G24) | risk-return tradeoff (G11) |
| predictors (short-term interest rate, dividend-price ratio, yield spread) (G12) | expected returns (G17) |
| predictability (asset return predictability) (G17) | variance and correlation structure of returns (C10) |
| predictability (D84) | risk dynamics (D81) |
| investment horizon (G11) | risk (D81) |