Bonds Versus Stocks: Investors' Age and Risk Taking

Abstract:     
This paper examines the proportion of wealth invested in stock and bond portfolios as a function of the investors' age, i.e., investment horizon. It has become increasingly popular to advice investors to relocate their funds from a primarily stock portfolio to a primarily bond portfolio as they get older. However, the existing theory does not support this advice: the well-known decision rules such as Mean-Variance (MV) or Stochastic Dominance (SD) rules are unable to explain this common practice. In this paper, we utilize the recently developed Almost Stochastic Dominance (ASD) and Almost Mean Variance (AMV) approaches and employ various datasets to examine the dominance of stock and bond portfolios as a function of the investment horizon. We find that, for short investment horizons, all portfolios are efficient. However, for medium and longer horizons, only the portfolios with higher stock proportions are efficient. The results indicate that ASD and AMV rules unambiguously support the popular practice of advising higher stock to bond ratio for long investment horizons. Hence, we provide an explanation to the practitioners' recommendation within the expected utility paradigm.

Keywords: Asset Allocation, Life-Cycle Funds, Almost Stochastic Dominance, Almost Mean-Variance

JEL Classifications: G10, G11, G12, C44, D81

Accepted Paper Series