Horizon Effects That Are Larger than You Think: Dynamic Allocation with a Representative Investor

Abstract

For investors who are more risk averse than the representative investor, the horizon effect in dynamic asset allocation is substantially larger than suggested in previous models that assume a constant risk-free rate. The illustrations here use a market setting with a representative investor who has a multiperiod horizon and a constant degree of relative risk aversion. If the market portfolio is mean-reverting, then the risk-free rate is not constant, and the market risk premium reflects the Merton intertemporal risk of unexpected changes in the market portfolio’s expected return.