How Important is Intertemporal Risk for Asset Allocation?

Abstract:     
How important is Merton's intertemporal risk for asset allocation decisions? To address this question we jointly estimate and test a conditional asset pricing model which includes long term interest rate risk as a potentially priced factor for four broad classes of assets - large stocks, small stocks, long term Treasury bonds and corporate bonds. We find that the premium for long bond risk is the main component of the risk premiums of Treasury bond and corporate bond portfolios, while it represents a small fraction of total risk premiums for equities. Our results suggest that investors perceive stocks and especially small stocks as hedges against variations in the investment opportunity set. Since these four asset classes represent some of the most important for investors, we proceed to use our estimates to compute the optimal asset allocations for investors who optimize with or without taking into account the intertemporal risk. We provide a set of measures to investigate the importance of this risk. We find that at average market volatility levels, investors can earn annual premiums between 3.6% during expansions and 5.8% during recessions for bearing intertemporal risk alone. These results underscore the importance of explicitly considering intertemporal risk in asset allocation decisions, especially during down markets and business recessions.

Number of Pages in PDF File: 48

working papers series