Implications of Long-Run Risk for Asset Allocation Decisions

This paper proposes a structural approach to long-horizon asset allocation. In particular, the investor draws inferences about asset returns from a vector autoregression (VAR) with economic restrictions on the intercept, slope, and covariance matrix implied by the long-run risk model of Bansal and Yaron (2004). Comparing the optimal allocations of investors using the long-run risk VAR versus an unrestricted reduced-form VAR reveals stark differences in portfolio strategies. Long-run risk investors are quite conservative relative to reduced-form investors due to intertemporal hedging concerns. Despite the differing strategies, both investors achieve success in timing the market. The gains of the long-run risk investor appear to arise from his ability to avoid exposure to large negative events, while the reduced-form investor better capitalizes on periods of high average returns