Dynamic asset allocation under mean-reverting returns, stochastic interest rates, and inflation uncertainty: Are popular recommendations consistent with rational behavior?

Abstract

This article provides the optimal asset allocation strategy of a power utility investor who can invest in cash (a bank account), nominal bonds, and stocks (the stock index) in a model that exhibits mean-reverting stock returns and real interest rate uncertainty. The capital market model is calibrated to U.S. stock, bond, and inflation data. Furthermore, to illustrate the optimal asset allocations, we perform a calibration exercise where risk aversion parameters and time horizons are fitted so as to obtain the best possible match to an observed investment recommendation for “aggressive,” “moderate,” and “conservative” investor groups with different investment horizons.