Optimal Portfolio Choice in Real Terms: Measuring the Benefits of TIPS

Abstract

In this paper, we solve an optimal portfolio choice problem to measure the benefits of Treasury Inflation Indexed Securities (TIPS) to investors concerned with maximizing real wealth. We show how the introduction of a real riskless asset completes the investor asset space, by contrasting optimal portfolio allocations with and without such assets. We use historical data to quantify gains from availability of TIPS in the presence of other asset classes such as equities, commodities, and real estate. We draw a distinction between buy-and-hold long-term investors for whom TIPS fully displace nominal riskfree assets and short-term investors for whom TIPS improve the investment opportunity set of real returns. Finally, we show how gains from TIPS are tempered by availability of alternative assets that covary with inflation, such as gold and real estate.

Keywords: Portfolio Choice in Real Terms, Treasury Inflation Indexed Securities (TIPS), Buy-and-hold Long-term Investors, Money Illusion

JEL Classification: G11