Climate Change and Long-Horizon Portfolio Choice: Combining Insights from Theory and Empirics

Abstract

We propose a novel approach to incorporating climate risk in long-horizon portfolio choice. Our method combines information from historical data about the impact of climate change on return dynamics with prior beliefs elicited from a temperature long-run risks (LRR-T) model. Investors with LRR-T beliefs perceive stocks to be much riskier over longer horizons because climate change weakens their beliefs in mean reversion and increases estimation risk and uncertainty about future expected returns. Because the perceived increase in long-horizon risk is not fully offset by higher equity premiums, the optimal allocation of buy-and-hold investors to equities decreases sharply with the horizon.

Keywords: climate change, long-run risks, prior beliefs, optimal portfolio choice, uncertainty

JEL Classification: C11, G11, G12, G23