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Implications of Long-Run Risk for Asset Allocation Decisions

36 Pages Posted: 28 Apr 2012  

Doron Avramov

Hebrew University of Jerusalem - Jerusalem School of Business Administration; The Chinese University of Hong Kong (CUHK)

Scott Cederburg

University of Arizona - Department of Finance

Date Written: March 1, 2012

Abstract

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 longrun 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.

JEL Classification: E21, E32, G11

Suggested Citation

Avramov, Doron and Cederburg, Scott, Implications of Long-Run Risk for Asset Allocation Decisions (March 1, 2012). Netspar Discussion Paper No. 03/2012-011. Available at SSRN: https://ssrn.com/abstract=2046566 or http://dx.doi.org/10.2139/ssrn.2046566

Doron Avramov

Hebrew University of Jerusalem - Jerusalem School of Business Administration ( email )

Mount Scopus
Jerusalem, 91905
Israel

HOME PAGE: http://pluto.huji.ac.il/~davramov/

The Chinese University of Hong Kong (CUHK)

Shatin, N.T.
Hong Kong
Hong Kong

Scott Cederburg (Contact Author)

University of Arizona - Department of Finance ( email )

McClelland Hall
P.O. Box 210108
Tucson, AZ 85721-0108
United States

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