Resolving the Asset Allocation Puzzle with Inter temporal Hedging and Nontraded Assets in the Stochastic Environment

Abstract

Canner, Mankiw and Weil (1997) point out that the popular financial advisors on portfolio allocation among cash, bonds and stocks appear not to follow the mutual-fund separation theorem and call the inconsistency between separation theorem and popular financial advice ”an asset allocation puzzle.” For solving the asset allocation puzzle, we provide an analysis of the optimal dynamic asset allocation strategy for a long-horizon investor who has nontraded assets under an economic environment with stochastic investment opportunities and incomplete financial markets. We propose another distinguishing hedging component of the dynamic asset allocation for the stock index fund: the human capital hedging component, the hedging demand which characterizes the demand arising from the desire to hedge against changes in the labor income in contrast to Merton (1973). When we incorporate nontraded assets with intertemporal hedging, we can solve the asset allocation puzzle successfully.