Journal of Economic Dynamics and Control

ELSEVIER 21 (1997) 1377-1403

Strategic asset allocation

Michael J. Brennana,bv*, Eduardo S. Schwartz’, Ronald Lagnadod
“Department of Bankingand Finance, University of California, Los Angeles, USA
bDepartment of Finance, London Business School, London, UK
‘Department of Real Estate and Finance. University of California, Los Angeles, USA
+ZATS

Abstract

This paper analyzes the portfolio problem of an investor who can invest in bonds,
stock, and cash when there is time variation in expected returns on the asset classes. The
time variation is assumed to be driven by three state variables, the short-term interest
rate, the rate on long-term bonds, and the dividend yield on a stock portfolio, which are
all assumed to follow a joint Markov process. The process is estimated from empirical
data and the investor’s optimal control problem is solved numerically for the resulting
parameter values. The optimal portfolio proportions of an investor with a long horizon
are compared with those of an investor with a short horizon such as is typically assumed
in ‘tactical asset allocation’ models: they are found to be significantly different. Out of
sample simulation results provide encouraging evidence that the predictability of asset
returns is sufficient for strategies that take it into account to yield significant improve-
ments in portfolio returns.

Keywords: Intertemporal portfolio theory; Stochastic control theory; Investment policy

JEL classification: GO, C6, D9

1. Introduction

One of the earliest applications of the portfolio theory developed by

Markowitz was to ‘tactical asset allocation’, the systematic allocation of invest-
ment portfolios across broad asset classes such as bonds, stock and cash.
Tactical asset allocation strategies have gained greatly in popularity in the wake

*Correspondence address: Michael J. Brennan, Anderson School of Management, UCLA, Los

Angeles, CA 90095-1481, USA. Telephone and fax: (310) 206-8419; e-mail: michael.brennan
@agsm.ucla.edu.

0165-1889/97/%17.00 0 1997 Elsevier Science B.V. All rights reserved

PII SOl65-1889(97)00031-6
1378 M.J. Brennan et al. /Journal of Economic Dynamics and Control 21 (1997) 1377-1403

of the Stock Market Crash of 1987, since those following the strategy managed
largely to avoid an overcommitment to equities immediately before the
Crash.
Tactical asset allocation is essentially a single period or myopic strategy; it
assumes that the decision maker has a (mean-variance) criterion defined over
the one period rate of return on the portfolio. This gives rise to two difficulties.
First, the expected rates of return that are inputs to the model are typically not
one-period expected rates of return, but rather estimated internal rates of return
over long holding periods. For example, the expected return on bonds is usually
proxied by the yield to maturity on a long-term bond, while the expected return
on stocks is the constant discount rate implied by a dividend discount model.
The implicit assumption in using these measures of expected return is that the
one-period expected return is proportional to the estimated long-run internal
rate of return - insofar as this assumption is not satisfied, the resulting portfolio
will be biased towards one or another of the asset classes. Therefore, it would
seem preferable to relate expected one-period rates of return to these proxies, for
example by regression analysis, and to use the predicted one-period rate of
return from the regression in the portfolio problem.
The second difficulty with tactical asset allocation is potentially more funda-
mental, in that it concerns the objective function. A sine qua non of tactical asset
allocation is time variation or predictability in expected asset returns - a market
in which asset returns conform to the random walk hypothesis would imply
constant portfolio proportions, at least for iso-elastic utility functions, or when
the mean variance criterion is defined over the rate of return on the portfolio.
There is now widespread evidence of predictability in asset returns,’ and Mossin
(1968) has shown that a single period or myopic objective function of the type
that underlies tactical asset allocation is appropriate only if the investor has
a logarithmic utility function. For general (non-log) utility functions the investor
will be concerned about hedging against shifts in the future investment oppor-
tunity set (changes in expected returns or covariances) - for an investor with
a long horizon, a drop in interest rates may be as important for his future welfare
as a substantial reduction in his current wealth. Similar considerations apply to
institutional investors such as pension funds, depending on the precise specifica-
tion of their objective function. 2 Merton (1971, 1990) has considered the prob-
lem of an investor planning his lifetime consumption and portfolio strategy.

‘See for example Keim and Stambaugh (1986), Fama and French (1988), Campbell and Shiller
(1988), Cochrane (1990), and Beckaert and Hodrick (1992).
‘Merton (1990) has made the interesting point to us that a university endowment fund may wish
to invest in property around the university in order to hedge against increases in property values
that would inhibit their ability to expand or to attract faculty on account of housing costs in the
locale.
 M.J. Brennan et al. /Journal of Economic Dynamics and Control 21 (I99!1 1377-1403 1379

Except for special cases3 it is not possible to obtain closed-form solutions for the
optimal strategies and, until recently, lack of computing power has made it
impracticable to solve realistic problems with time varying expected returns.
In this paper we formulate and solve the portfolio problem of an investor who
has a long-term horizon, with utility defined over wealth at the end of the
horizon4 when the structure of expected returns may be described by a small
number of state variables which follow a joint Markov process. The investor is
assumed to invest in three assets - an instantaneously riskless security, ‘cash’,
a long-term (consol) bond, and an equity portfolio. The variables that predict
expected returns on these assets are the instantaneously riskless interest rate (the
‘short rate’), the yield on the consol bond (the ‘long rate’), and the dividend yield
on the equity portfolio (the ‘dividend yield’). While the model as formulated here
assumes that the investor has no liabilities, it is relatively straightforward to
generalize it to allow for liabilities whose expected rate of increase depends on
the levels of the state variables - this will be important if we are to apply the
model to the planning problem of a pension fund. Finally, we ignore here any
problems of inflation; again, for practical implementation it will be important to
incorporate stochastic inflation in the analysis. Our objective is to compare the
portfolio strategies implied by a myopic objective function which ignores
changes in the future investment opportunity set, with those implied by optimal
behavior for an investor with a long-term horizon.
The stochastic optimal control problem that we formulate, following Merton
(1971), may be contrasted with the stochastic programming approach which has
been followed by several recent authors.’ The essential difference between the
two approaches is the way in which the uncertainty in the environment is
modelled. The stochastic optimal control problem captures uncertainty by
allowing for a continuum of states6 which can be described at a given point in
time by a small number of state variables that follow a joint Markov process; the
size of the stochastic optimal control problem grows exponentially with the
number of state variables, which limits the applicability of the approach to
situations in which it is reasonable to model the state of the world by a relatively
small number of state variables. In the application described here, the state of
the world depends only on the investment opportunities which are captured by
three state variables: two interest rates and the dividend yield on an equity
portfolio. Given this, a problem with 480 time steps over 20 years can be solved
in a matter of hours on a Pentium PC. However, such a parsimonious state

%ee Merton (1990, Chapter 5).

41t is a simple extension to allow for utility from intermediate ‘consumption’ withdrawals.
‘See for example Carino et al. (1994), and Mulvey and Vladimirou (1992).
‘% practice, it is usually necessary to discretize the state space for computational purposes.
1380 M.J. Brennan et al. /Journal ofEconomic Dynamics and Control 21 (1997) 1377-1403

description would be inadequate, for example, if transactions costs were impor-

tant,7 or if the agent had non-tradable stochastic assets or liabilities, for then the
exact composition of the asset or liability portfolio at each point in time would
become relevant, and this would vastly expand the state space. On the other
hand, the approach does allow consideration of a large number of investment
assets, for the problem grows only linearly in the number of assets, and portfolio
constraints are easy to implement provided that they depend on current market
values and not on historical book values, for the book values would then
become part of the state vector, again vastly expanding the state space.
Stochastic programming models capture uncertainty by a branching event
tree. Each node of the tree represents a joint outcome of all the random variables
at that decision stage, and corresponds to a particular realization of the state
variables at a point in time in the stochastic optimal control approach. The
major advantage of stochastic programming is that it can easily accommodate
a large number of random variables at each node, and thus permits a very rich
description of the state of the world, which may include the book value of all
assets and liabilities (which may be important for regulatory reasons or on
account of a capital gains tax), the age and sex composition of the workforce
(which may be relevant for a pension fund), as well as market values of each asset
and liability class which may be important if transaction costs are significant.
Each path through the event tree represents a ‘scenario’. The total number of
scenarios depends mutiplicatively on the number of branches from each node
and the number of time steps or decision nodes. For example, ten time steps and
three branches from each node implies 59,049 different scenarios; while prob-
lems of this order of magnitude can now be solved,’ they are highly computer
intensive. Moreover, three branches (or even ten) emanating from a single node
can provide only a very limited description of the uncertainty facing the decision
maker over the next decision interval.g As Mulvey and Vladimirou (1992, p.
1661) point out, ‘Statistical methods . . . can limit the required number of
scenarios to properly capture uncertainty and maintain computational trac-
tability . . . These issues are the subject of active research’. Thus stochastic
optimal control and stochastic programming approaches can be viewed as
complementary rather than competing. The former approach has significant
computational advantages where the problem under consideration can be

‘We do not regard transactions costs as important for trading between major asset classes in
modem capital markets, for such portfolio adjustments can be effected by trading in futures
contracts at minimal cost.
‘Jessup et al. (1994) solve a problem with 98,000 scenarios in 23 seconds on the Intel iPSC/860
Connection Machine CM-5
‘For example, in the absence of transaction costs or constraints on portfolio holdings the
optimization problem at a node with n branches can determine at most the values of the positions in
n different assets.
 M.J. Brennan et al. /Journal ofEconomic Dynamics and Control 21 (1997) 1377-1403 1381

adequately represented in terms of a small number of state variables that follow

a joint Markov process. The latter is the only alternative where the number of
state variables is large, and it has been suggested to uslo that with developments
in interior point algorithms, and with the potential use of parallel and distrib-
uted computations, stochastic programs with thousands or millions of scenarios
become solvable.’ ’ Significant practical or commercial applications of stochas-
tic programming include Carino et al. (1994) who describe a case study of
a Japanese insurance company with 256 scenarios, with eight branches from the
initial node and two or three thereafter, Mulvey (1994) who analyzes an asset-
liability problem, Mulvey and Vladimirou (1992) who analyze a variety of
financial planning problems with up to 8 periods and 100 scenarios, and Zenios
(1993) who develops a model for the management of a portfolio of mortgage-
backed securities. We are aware of no practical or commercial applications of
stochastic optimal control theory in asset management.
In Section 1 we illustrate the essential difference between myopic portfolio
selection and dynamic (‘strategic’) strategies, using a simple two-period example
in which wealth may be invested in short- or long-term bonds. In Section 2 we
present the optimal control problem. Section 3 specifies the stochastic process
for the state variables and presents empirical estimates of the parameters.
Section 4 discusses the solution of the control problem and Section 5 discusses
the differences between the portfolio composition under an optimal policy with
that under a myopic strategy.

2. zyxwvutsrqponmlkjihgfedcbaZYXWVUTSRQPONMLKJIHGFEDCBA
A simple example

Consider an investor with initial wealth zyxwvutsrqponmlkjihgfedcbaZYXWVUT

W who is interested in maximizing
the expected utility of wealth at the end of a two period horizon. Assume that his
utility function is of the iso-elastic family:

U(w)=;w? (I)

At time t (t = 0, 1,2) the investor’s expected utility under the optimal policy will
depend on both his current wealth, W, and the investment opportunities he
faces, which we assume can be represented by a vector Y, V( W, Y, t). We assume
for illustrative purposes that the investor’s investment opportunities are limited
to a one-period bond and a two-period bond, and that the pure zyxwvutsrqponmlkjihg
expectations

“By a referee of this journal

“See Mulvey and Ruszczynski (1995), and Jessup et al. (1994)
1382 M.J. Bremnn et al. / Jound qfEconon~ic Dynamics and Control 21 (1997) 1377-1403

t=o t=1 t=2

ONE PERIOD INTEREST RATE

8.18% State I3
l/2

10%
<
l/2 11.81% State A

TWO PERIOD BOND PRICE

- 100 State B

82.67

- 100 State A

Fig. 1. Binomial model of bond pricing under the pure expectations hypothesis.

hypothesis holds so that the expected return on the one and two-period bonds
are the same. The one-period interest rate is assumed to follow a binomial
process with binomial probability of l/2 as shown in Fig. 1. The two-period
bond price at t = 1 is obtained by discounting the final payoff at the relevant one
period rate; the price at t = 0 is obtained by discounting the expected value of
the bond at t = 1 by the riskless rate of 10% at t = 0.” We have not considered
a two-period bond in the second investment period, since a risk averse investor
with a single-period horizon would never invest in an asset whose return is risky,
if its expected return is equal to the riskless rate.r3
First, note that a myopic risk averse investor will not invest anything in the
two-period bond in the first period, since its return is risky and its expected
return is only the same as the riskless return available on the one-period bond.

“It is at this stage that we are using the expectations hypothesis.

‘%ee Arrow (1971).
 M.J. Brennan e-1al. 1 Journal of Economic Dynamics and Control .?I (1997) 1377-1403 1383

Table 1
Optimal allocation to two-period bond (x) as a function of the coefficient of relative risk aversion (y)

Y 0.9 0.5 0.0 - 0.5 - 0.9 - 2.0

x - 8.9 - 1.0 0.0 0.3 0.4 0.7

However, an investor who behaves optimally will recognize that the long-term
bond has a low return in State A, but that this is compensated for by the higher
reinvestment rate in State A, and conversely for State B. Thus the two-period
bond may allow the investor to hedge against changes in the future investment
opportunity set as represented here by the one-period interest rate in the second
period. As a result, the investor may find it advantageous to take a position in
the two period bond in the first period. Since the investor invests only in the one
period bond in the second period, his final wealth in the two states may be
written as
WA = 1.1181W0{1.1 + x(0.0818 - O.l)},

WB = 1.0818W0{1.1 + x(0.1181 - O.l)},

where x is the fraction of wealth allocated to the two-period bond in the first
period. The investor chooses x to maximize

V(We, lO%, 0) = 0.5w; + 0.5w1;.

The optimal values of x for different values of the risk aversion parameter, y, are
shown in Table 1. It is seen that for y > 0 it is optimal for the investor to short
the two-period bond, while for y < 0, it is optimal for the investor to take a long
position. Only for y = 0, which corresponds to the log function, is it optimal for
the investor to take no position - for this utility function the investor behaves
myopically and, as we noted, a myopic risk averse investor will not invest in
a risky asset unless it offers a positive risk premium. Thus, this example
illustrates the main point of the paper, that whereas a myopic or single-period
investor will treat a long-term bond as simply another risky asset, an investor
with a long-term horizon will recognize also the ability of the bond to hedge
against future changes in the investment opportunity set. In more complex
settings other risky assets may have similar hedging characteristics.

3. zyxwvutsrqponmlkjihgfedcbaZYXWVUTSRQPONMLKJIHGFEDCBA
The optimal control problem

In selecting state variables to represent the opportunity set of the investor we

were guided by the need for parsimony, since the size of the control problem
grows geometrically with the number of state variables. The short term interest
1384 M.J. Brennan et al. / Journal of Economic Dynamics and Control 21 (1997) 1377-1403

rate, Y,was selected as a state variable, both because it is the return on an asset
class, and because there is extensive evidence that the level of the short rate
predicts the expected return on common stock.14 The second most powerful
predictor of stock returns is the dividend yield on common stocks,15 6, and
therefore this was included as the second state variable. Finally, we included the
yield on a consol bond, zyxwvutsrqponmlkjihgfedcbaZYXWVUTSRQPONMLKJIH
1,as the third state variable, because of prior evidence
that expected changes in the short rate are related to the current value of the
long rate. l6 A fourth possible candidate is the junk bond yield spread, because
there is evidence that this has predictive power for stock returns in addition to
dividend yields and interest rates, .17 however, we did not include a fourth state
variable in our analysis on account of limitations in computing power. Denoting
the rate of return on the stock portfolio by dS/S, the joint stochastic process for
the state variables is assumed to be of the form:

dS
- = psdt + a,dzs,
s

dr = /~~dt + ~,dz,, (4)

dl = ,u,dt + c,dz,, (5)

where the parameters pi, Oi (i = r, I, 6, S) are at most functions of the state

variables Y, 1, 6, and dzi are increments to Wiener processes. The correlation
coefficients between the increments to the Wiener processes are denoted by pig,
etc.
The three asset classes assumed to be available to the investor for investment
are cash with sure rate of return, r; stock, whose rate of return is given by Eq. (3);
and consol bonds. The price of a consol bond, B(I), is inversely proportional to
its yield, 1.The total return on a consol bond is the sum of the yield and the price
change; then a simple application of Ito’s lemma implies that the instantaneous

14An early study drawing attention to the importance of this variable is Lintner (1975). More
recent studies include Keim and Stambaugh (1986) and Hodrick (1991). Attempts to account for this
empirical regularity include Geske and Roll (1983) and Fama (1981).
‘%ee, for example, Fama and French (1988).
‘%ee Brennan and Schwartz (1982); this is a natural implication of expectations-based theories of
the term structure.
“See Keim and Stambaugh (1986).
 M J. Brennan et al. /Journal of Economic Dynamics and Control 21 (1997) 1377-1403 1385

total return on the consol bond is given by

y+idf=(i-T+$)d+dr,. (7)

Define x as the proportion of the investment portfolio that is invested in stock,

and y the proportion that is invested in the consol bond. Then the stochastic
process for wealth, zyxwvutsrqponmlkjihgfedcbaZYXWVUTSRQPONMLKJIHG
W, is:

F=[xT+y(;+ldt)+(l -x-y)rdr

1
a:
= x(p,-r)+y l-r-T+- +r dt
[ ( P ) zyxwvutsrqponmlkjihgfedcbaZYXWVUT

E p,,, dt + o,dz,. (8)

Define V(r, I, 6, W, T) as the expected utility under the optimal policy when there
are T periods to the horizon. Then the Bellman equation is

Max E[dV] = 0 (9)

X3Y

Ma x C ~,c c ,W + v,p c , + vlp l + v&d - J” ,

x. Y

+iTlr,, o ;W2+fvllo ; +$Vlla : +fI/ &5a d Z

+ ~W6W~6~wPb w + ~rPr~,~IPrl + ~rd ~r~.d Pn5

+ ~WrW(m vPrw + VwlWflIwh + ~,h~lfJdPkJ

= 0. (10)
zyxwvutsrqponmlkjihgfedcbaZYXWVU
As specified, the control problem (10) has four state variables including W. In
order to reduce the number of state variables, we assume that utility is of the
isoelastic form so that

V(r,1,6, w,o)=;wy, for y < 1. (11)

Then it may be verified that V(r, 1,6, W, z) may be written as y - ’ W y u(r, I,& T),
where

v(r,1,6,0)= 1 (12)
1386 M.J. Brennan et al. / Journal of Economic Dy namics and Control 21 (1997) 1377- 1403

1 1 1 1
+ T(” - 1)&u + -&I,, + -cJ:u,, +-C-&J&?
2Y 2Y 2Y

(13)

(14)

Substituting for p,,, and collecting terms, we have finally:

+r
x. Y
1 c2
+ ,(r - l)(x%,Z + y2-t- -
2xya,blPSl
I >I
I2 zyxwvutsrqponmlkjihgfedcbaZYXWVUTSRQPONML

The first-order conditions for a maximum in (15) imply that the optimal
controls, x* = x*(r, I, S, z) and y* E y*(r, I, 6, z), are given by
1 a?
-+-~)+QSI ,-++$
x* = (y - l)(a$ - afaf) [ ( >

(16)
 D~vnamics cmd Cor~trol -71 (1997) 1377-1403 1387

4. The stochastic process

In order to estimate the joint stochastic process (3)-(6) for the state variables
and the stock return, it is necessary to specify the functional forms of the drift
and diffusion coefficients. The basic assumption we made was that the expected
returns on stocks and bonds, and the drifts of the dividend yield and short rate.
were linear functions of the three state variables, r, I, and 6, while the volatility of
each state variable was assumed to be proportional to its current level, and the
volatility of the stock rate of return was taken as constant. This implies from
Eq. (7) that the drift of the long rate is a non-linear function of the state
variables, being equal to the product of I and a linear function of the state
variables. This specification implies that the joint stochastic process may be
written as

us3r + a,,l)dt + a,dz,, (18)

dr = (a,., + ar26 + ur3r + a,,l)dt + ro*dz,, (19)

dl = l(u,l + u/z6 + a131 + u&dt + Ig,dzl, (20)

d6 = (aa + ~~~6 + zyxwvutsrqponmlkjihgfedcbaZYXWVUTSRQPONMLKJ

uJ3r + ud,l)dt + 6g6dz,. (21)

The dividend yield is defined as the sum of the past 12 months’ dividends
divided by the current level of the stock index, S. The specification (21) must
therefore be regarded as an approximation since the stochastic process for
lagged dividends is not modelled explicitly; to have done so would have
introduced a fourth state variable into the analysis which would have consider-
ably increased the difficulty of solving the control problem. However, we expect
that the stochastic increment to the dividend yield will have a strong negative
correlation with the return on the stock, since most of the stock return is
accounted for by price changes.
The joint stochastic process was estimated by using a discrete approximation
to the continuous process, and using monthly data for the period January 1972
to December 1991. The stock return was taken as the rate of return on CRSP
value weighted market index. The short rate was taken as the yield on a one
1388 zyxwvutsrqponmlkjihgfedcbaZYXWVUTSRQPONMLKJIHGFEDCBA
M.J. Brennan et al. / Journal of Economic Dy namics and Control 21 (1997) 1377- 1403

month Treasury Bill which was taken from the CRSP Government Bond File.
The long rate was taken as the yield to maturity on the longest maturity taxable,
non-callable government bond, excluding flower bonds; bond yield data were
from the CRSP Government Bond File. The dividend yield was defined as the
sum of the past 12 months’ dividends on the CRSP value weighted index, divided
by the current value of the index.
The system of Eqs. (18)-(21) was estimated by non-linear seemingly unrelated
regression using TSP. Table 2 reports the regression estimates and Table 3
contains the estimated correlations of the innovations. As previous investigators
have found, the expected return on common stocks is negatively related to the
current level of the short rate and positively related to the level of the dividend
yield, but is not significantly related to the long rate. As Brennan and Schwartz
(1982) have found, the change in the short rate is negatively related to its current
level and positively related to the level of the long rate - thus the short rate tends
to adjust towards the long rate. The change in the long rate itself is the least
predictable of our series, being negatively related to its current level and
positively related to the short rate at marginal levels of significance. The change

Table 2
The estimated stochastic process for the state variables and the market return: January 1972-
December 1991

b r I IJ

dS/S - 0.022 1.707 - 0.513 - 0.017 0.045

(1.63) (3.95) (3.25) (0.08)
dr - 0.001 0.0048 - 0.216 0.181 0.134
(0.34) (0.05) ( - 5.66) (3.54)
dl 0.025 - 0.318 0.247 - 0.308 0.037
(1.82) (0.79) (1.68) (1.55)
db 0.0009 - 0.059 0.023 0.0005 0.048
(1.62) (2.97) (3.27) (0.05)

r-statistics in parentheses.

Table 3
Correlations of state variable and stock return innovations: January 1972-December 1991

Stock return r I 6

Stock return 1.0

r - 0.037 1.0
1 - 0.330 0.330 1.0
b - 0.995 0.032 0.298 1.0
 M.J. Brennan et al. /Journal ofEconomic Dy namics and Control 21 (1997) 1377- 1403 13X9

in the dividend yield is negatively related to its current level, so that it shows
mean reversion; in addition, it is positively related to the short rate. As anticip-
ated, the innovation in the dividend yield is very highly negatively correlated
with the innovation in stock returns; it is also positively correlated with the
innovation in the long rate, because the innovation in the long rate is negatively
correlated with the innovation in stock returns. The remaining innovations have
very low correlations.
In solving the control problem we shall truncate the state space by eliminating
states in which the variables assume high values, beyond the range of US
experience. It is important therefore that the state variables under the estimated
stochastic process be stationary and not tend towards the boundary of our
truncated state space if they are started at values within the range of historical
experience. It is not possible to evaluate formally the stability of the stochastic
differential equation system on account of the non-linearity entering through
the equation for 1. Therefore, we followed the empirical procedure of starting the
system at points corresponding to historical joint realizations of the state
variables, and then simulating the system forward while setting the innovations
equal to zero: in all cases the system converged. Figs. 2 and 3 show the results of

Fig. 2. The evolution of the state variables r, I and 6 starting from their values on 29 March 1974 to
December 1991, as determined by the nonstochastic part of the process (18)-(21) with parameter
values as reported in Table 2. For comparison, the actual evolution of the state variables is also
shown.
1390 M.J. Btznnan et al. / Journal zyxwvutsrqponmlkjihgfedcbaZYXWVUTSRQPONMLKJIHG
of Economic Dynamics and Control 21 (1997) 1377-1403

0’12
l------T

OJ - _+_ .-
N w x !:

Fig. 3. The evolution of the state variables r, I and 6 starting from their values on 30 September 1987
to December 1991, as determined by the nonstochastic part of the process (18)-(21) with parameter
values as reported in Table 2. For comparison, the actual evolution of the state variables is also
shown.

two representative simulations, with the actual realizations of the state variables
being shown along with the simulated values. It can be seen that the system
settles down to its long-run steady state which corresponds roughly to 1 = 9%,
I = 8%, and 6 = 4%. We conclude that the system is sufficiently well behaved to
provide a useful input to our model. Fig. 4 shows the time series of annualized
expected returns on the three asset classes that are implied by the model
parameters. The expected returns on bonds and stock generally exceed the cash
return, the notable exceptions being at the beginning of the 1970s when the
expected returns on both bonds and stock are negative and, more particularly,
at the beginning of the 198Os,when the very high short rate drives the estimated
expected return on stocks negative for a prolonged period.‘*
In order to test the stability of the stochastic process, the system (18)-(21)
was re-estimated for the two halves of the sample period, and the parameter

‘sBoudoukh et al. (1993) also report ‘reliable evidence that the ex-ante risk premium is negative in
some states of the world; these states are related to periods to high expected inflation and especially
to downward-sloping term structures’.
 M.J. B~-tmr~an
er 01. / Journal ofEconomic Dy namics und Co~lrr- 0131 (1997j 1377- 1403 1391

-0.4 ’
1972 1976 1980 1994 1988
1974 1978 1982 1986 1999

Fig. 4. For each month the annualized expected returns on bonds, stock and cash implied by the
stochastic processes (18), (20), and the contemporaneous values of the state variables r, 1and 6. The
parameter values for the stochastic processes are reported in Table 2.

Table 4a
Estimates for the first half of the sample period: January 1972-December 1981

Constant 6 I 1 0

dS/S - 0.040 1.356 - 0.624 0.420 0.044

(2.01) (2.63) (2.66) (I .06)
dr 0.000 - 0.090 - 0.067 0.108 0.106
(0.08) (1.00) (1.29) (1.18)
dl/l 0.010 - 0.156 0.188 - 0.120 0.036
(0.54) (0.33) (0.80) (0.32)
dr? 0.001 - 0.033 0.027 - 0.018 0.048
(1.50) (1.42) (2.56) (0.91)

Log-likelihood: 908.
t-ratios in parentheses.

estimates are reported in Table 4a and 4b. While the coefficients are generally
similar across the two sub-periods, we note that both the effect of the dividend
yield on the stock return and the effect of the level of the short rate on the change
in itself are much greater in the second half of the sample period. A likelihood
1392 zyxwvutsrqponmlkjihgfedcbaZYXWVUTSRQPONMLKJIHGFEDCBA
M.J. Brennan et al. / Journal of Economic Dy namics and Control 21 (1997) 1377- 1403

Table 4b
Estimates for the second half of the sample period: January 1982-December 1991

Constant 6 r 1 0

dS/S - 0.031 3.866 - 0.720 - 0.662 0.044

(1.35) (4.11) (2.39) (1.59)
dr 0.000 - 0.011 - 0.384 0.272 0.146
(0.08) (0.04) (6.41) (2.75)
d//l 0.045 - 1.503 0.223 - 0.037 0.037
(2.10) (1.66) (0.8 1) (0.10)
d6 0.002 - 0.170 0.03 1 0.028 0.047
(1.81) (4.00) (2.35) (1.61)

Log-likelihood: 828.
t-ratios in parentheses.

ratio test of the equality of the coefficients across the subperiods yields
a x2 statistic of 58 with 16 degrees of freedom which is sufficient to reject
the null hypothesis of constant coefficients at the 1% level. In an effort to allow
for the effects of time variation in the coefficients we shall examine the perfor-
mance of the optimal strategy when it is based on out-of-sample parameter
estimates.

5. Numerical solution of the control problem

Substitution of the expressions (16) and (17) for the optimal controls into
expression (15) yields a non-linear partial differential equation for v. The equa-
tion was solved using an implicit finite difference approximation on
a (40 x 40 x 20) grid. The second-order partial derivatives with respect to the
state variables were discretized using second-order accurate central difference
approximations. The first-order partial derivatives with respect to the state
variables, on the other hand, were discretized using first-order accurate upwind
difference approximations. This choice of upwind differencing was found to
enhance the stability and convergence rate of the relaxation method used to
solve the discrete system of equations. The interest rates were allowed to range
from zero to 20% and the dividend yield from zero to 10%. Thus the step size in
each of the state variables was 0.5%. The time step was set at approximately two
weeks (l/24 yr). For each time step, initial trial values of the controls, x* and y*,
were computed using values of the partial derivatives from the previous time
step. Current values of ~(6, I, 1, T) were then calculated from the partial differen-
tial equation using successive over relaxation, and the controls were then
re-computed using values of the partial derivatives from the currently computed
 M.J. Brennat~ et al. / Journal of Economic Qvnamics and Control 21 (1997) 1377-1403 1393

values oft’ ( ). The new controls were then used to compute new values of u( );
this procedure was repeated for a total of three iterations, and yielded satisfac-
tory convergence.
In solving the equation, the following boundary conditions were imposed:

v, = 0 r = 0, zyxwvutsrqponmlkjihgfedcbaZYXWVUTSRQPONMLKJIHGFEDCBA
at zyxwvutsrqponmlkjihgfedcbaZYXWVUTSRQPONMLKJIHGFEDCBA

V *I = 0 at r = 0.2,

v, = 0 at 1 = 0,

V,{= 0 at I = 0.2,

vd = 0 at 6 = 0,

va6 = 0 at 6 = 0.1.

For a 20 yr horizon (480 time steps) problem the program, which was written
in FORTRAN, required about two CPU hours on a SUN SPARCstation 10 or
about six hours on a Pentium PC.

6. Results

The control problem was solved for a value of y equal to - 5, both with and
without constraints on short positions, and with a horizon of 20 yr. This rather
extreme value of the risk aversion coefficient was chosen to offset our treatment
of the parameters of the stochastic process as known when they are in fact
estimated and therefore subject to estimation error.” The main results are
shown in Figs. 5-7 which show the optimal portfolio proportions when no short
sales are allowed, for the values of the state variables realized over the sample
period.
The portfolio proportions are calculated for three distinct strategies. First,
under the assumption that the horizon is a constant 20 years - the ‘20 year’
strategy. Secondly, under the assumption that the horizon is always 1 month
_ the ‘1 month’ strategy: this strategy is intended to represent the myopic
strategy that underlies tactical asset allocation. Finally, under the assumption
that the horizon is 1 January 1992 - the ‘1992’ strategy; under this strategy the
horizon used to calculate the portfolio proportions in any given month is the
number of months remaining to January 1992.

lgFor an analysis of estimation error in (single period) portfolio problems see Bawa et al. (1979).
For intertemporal problems with learning see Gennotte (1986).
1394 zyxwvutsrqponmlkjihgfedcbaZYXWVUTSRQPONMLKJIHGFEDCBA
M.J. Brennan et al. / Journal o/Economic Dy namics and Control 21 (1997) 1377- 1403

0.0

0.8

0.7

0.6

0.5

0.4

0.3

0.2

0.1

0
Jan-72 Jan-74 Jaw76 Jan-78 Jew80 Jan-82 Jan-84 JBR86 Ja”-O* Jan-80

-----1MOnth -ZOYesr-1982

Fig. 5. For each month the proportion of the portfolio allocated to cash under the 1 month, 20 yr
and 1992 strategies when the portfolio proportions are constrained to be non-negative. The
parameter values for the stochastic processes used in the optimization are reported in Table 2.

Fig. 5 plots the cash proportions under the three strategies. We note that for
all three strategies the cash ratio varies at least between zero and 90% and is
highly volatile. 2o The one-month strategy usually involves a higher cash posi-
tion than the 20 yr strategy. The reason for this is that cash is riskless over
a one-month horizon, but it is not riskless for someone with a 20 yr horizon
because of the uncertainty surrounding the re-investment rate.*’ As one would
expect, the 1992 strategy cash proportion starts out identical with the 20 yr
strategy and converges to that of the one-month strategy.
Fig. 6 plots the stock proportions which range between zero and 100% and
again are highly volatile. The 20 yr strategy always invests more in stock than
the one-month strategy, and the differences are often large; for example, in late
1979 the one-month strategy places only about 10% of the portfolio in stock
while the 20 yr strategy places 65%. As before, the 1992 strategy is intermediate

rOOur analysis does not include costs of transacting in the securities. However, as DuBois (1992)
notes in connection with tactical asset allocation (TAA), the development of futures markets means
that ‘currently, transaction costs ofTAA implementations appear to be less than a tenth of those that
existed, say, 10 years ago. Hence a significant impediment to the viability of TAA strategies has been
largely eliminated for today’s TAA managers’. Clarke (1992) estimates the round-trip costs in futures
markets at 7-12 basis points including market impact.
Z*See Hicks (1946) for the distinction between capital risk and income risk - the former is relevant
for someone with a short horizon while the latter becomes more important as the horizon lengthens.
 M.J. Brennan Ed al. /Journal of‘Economic Dy namics and Control 21 j1997) 1377- 1403 I395

JS”-72 Jan-74 Jan-76 Jan-78 Jan-80 .k”-82 Jan.84 JaGi Jan-88 Jan-90

Fig. 6. For each month the proportion of the portfolio allocated to stock under the 1 month, 20 yr
and 1992 strategies when the portfolio proportions are constrained to be non-negative. The
parameter values for the stochastic processes used in the optimization are reported in Table 2.

1.00
0.00 r--.--- zyxwvutsrqponmlkjihgfedcbaZYXWVUTSRQPONMLKJIHGFED

I
0.80

0.70

0.80

0.40

0.50
0.30

0.20

0.10k
1
zyxwvutsrqponmlkjihgfedcbaZYXWVUTSRQPONMLKJIHGFEDCBA
A
0.00 A $h
Jan-72 Jan-74 Jan-76 Jan-7a Jar&O Jan-82 Jaw34 Jan-86 JSll-88 J&U?-90

-----lMonth---ZOYeaars-1902

Fig. 7. For each month the proportion of the portfolio allocated to bonds under the 1 month, 20 yr
and 1992 strategies when the portfolio proportions are constrained to be non-negative. The
parameter values for the stochastic processes used in the optimization are reported in Table 2.

between these two. The intuition for the greater investment in stock for the
long-horizon strategy is that the mean reversion in stock prices induced by the
dividend yield variable means that the volatility of the distribution of (the log of)
future (dividend adjusted) stock prices grows less than proportionately with
time, so that stocks are less risky for those with a long horizon.
 of zyxwvutsrqponmlkjihgfedcbaZYXWVUTSRQPONM
1396 M.J. Brennan er al. / Journal zyxwvutsrqponmlkjihgfedcbaZYXWVUTSRQPONMLKJIHG
Economic Dynamics and Control 21 (1997) 1377-1403

Fig. 7 plots the bond proportions. These are close to zero through the 197Os,
then high and volatile in the 1980s and low again in the 1990s. While intuition
suggests that the 20 yr strategy would always assign a larger proportion to
bonds than the one-month strategy, it is interesting to note that this is not
always the case. For example, in January 1982 the 20 yr strategy assigns about
15% of the portfolio to bonds, while the one month strategy assigns around
90%, and the one-month strategy allocation to bonds exceeds that of the 20 yr
strategy through most of the first half of the 1980s. The difference in the bond
allocations is highly variable over time, suggesting that rules of thumb to adjust
tactical asset allocation portfolios to account for a longer horizon are unlikely to
be successful.22
In order to assess the performance of the strategy when out-of sample
parameter estimates for the stochastic process are used to derive the optimal
strategy, the optimal strategy was computed for each year of the second half of
the sample period, January 1982 - December 1991, using parameter values
estimated over the previous ten years. Thus the parameter estimates on which
the optimal strategy is based are updated annually, always using the data on
dividend yield and interest rates from the previous ten years. This strategy was
then combined with the current values of the state variables to compute the
optimal portfolio proportions for each month of the second half of the sample
period, and the returns on this ‘out-of-sample’ strategy were calculated. The
average monthly turnover was 89.6% per month for the unconstrained strategy,
but only 22.5% per month for the constrained strategy. Figs. 8 and 9 report the
out-of sample wealth relatives for the l-month, 10 yr, and 1992 strategies along
with the wealth relative for a pure stock investment for comparison.
Fig. 9 relates to a strategy in which the portfolio proportions are constrained to
be non-negative, while Fig. 8 relates to an unconstrained strategy. It may be seen
in Fig. 8 that the unconstrained 1992 strategy performs slightly worse than the
one-month strategy, but better than the other strategies over this sample period.
However, when the strategies are constrained from taking negative positions,
the 1992 strategy yields the highest final wealth outcome, as shown in Figure 9.
The standard deviations and means of the monthly returns of the different
strategies are reported in Table 5. It may be seen first that the standard deviation
of the 1992 and 10 yr strategies are larger than those of the one-month strategy;
as mentioned previously, the long-term strategic strategies accept more short-
term risk than the one-month strategy because of the mean reversion in stock
prices and relation between negative bond returns and higher future interest
rates. The constrained strategies have both lower means and lower standard

“Some practitioners of tactical asset allocation (TAA) for pension funds construct a duration
matched bond portfolio to mimic the liability portfolio, and practice TAA with the portfolio surplus.
The results here suggest that this will not approximate the optimal strategy for a long horizon.
 M.J. Brennun et al. / Journal of Economic Dy namws and Control 21 (1997) 1377- 1403 1397 zyxwvuts

1000

9 00

6.00

7.00

6 00

4.00

3.00

2.00

I.00

0.00 ti
Jail-82 Jam83 JBk&( Jan-85 JUF38 Jan-87 JBW88 Jan-89 Jtlll-90 Jan-91 JSWl-92

- w.2) ---- w(lmth) -----w(,Oyr) - - - - Sock

Fig. 8. The wealth relatives obtained by following the optimal 1992 strategy (w(92)), the optimal
one-month strategy (w(lmth)), the optimal constant 10 yr horizon strategy (w(lOyr)) and an all stock
strategy (stock). The optimal strategies for each calendar year are determined using parameter
estimates for the stochastic process (18)-(21) obtained using 10yrs’ data ending the previous
December. The portfolio proportions are not constrained to be non-negative.

4
Jan-82 Jan-33 Jail-84 Janas JUI.86 JPn.87 JOn-88 JBW.39 JllllgO Jan-91 Jan-92

- zyxwvutsrqponmlkjihgfedcbaZYXWVUTSRQPONMLKJIHGFEDCBA
w (Q2)
_---w(,m,h) -.-.-rv(,oyr) . . . . . . . d@&

Fig. 9. The wealth relatives obtained by following the optimal 1992 strategy (w(92)), the optimal
I month strategy (w(lmth)), the optimal constant 10 yr horizon strategy (w(lOyr)) and an all stock
strategy (stock). The optimal strategies for each calendar year are determined using parameter
estimates for the stochastic process (18)-(21) obtained using 10yrs’ data ending the previous
December. The portfolio proportions are constrained to be non-negative.
1398 M.J. Brennan et al. / Journal of Economic Dy namics and Control 21 (1997) 1377- 1403

Table 5
Means(p) and standard deviations (a) ofmonthly returns under alternative out ofsample investment
strategies 1982-1991

Strategy

Cash 0.005
Bonds 0.012
Stock 0.015
Unconstrained: one-month horizon 0.022
Unconstrained: 1992 horison 0.022
Unconstrained: 10 yr horizon 0.084 0.021
Constrained: one-month horizon 0.028 0.013
Constrained: 1992 horizon 0.03 1 0.015
Constrained: 10 yr horizon 0.03 1 0.014

deviations than the unconstrained strategies. Some indication of the out of

sample power of the model is provided by the fact that the constrained 1992
strategy has the same mean return as the all stocks strategy, but a monthly
standard deviation of 3.1% as compared with 4.7% for the all stock strategy.
However, strictly speaking, it is inappropriate to compare the different strat-
egies on the basis of a mean-variance criterion since, while the one-month
strategy is approximately mean variance efficient,23 the long-term strategies
maximize the expected value of a (derived) utility function that depends on the
state variables as well as on wealth. To see the importance of the distinction note
that a strategy that invested in a pure discount bond which matured at the
horizon would be riskless, but the standard deviation of the monthly returns
would not be zero if there was variation in the interest rate. Therefore a better
metric by which to assess the relative risk of the strategies is the variance of the
certainty equivalent of wealth, CE( W , r, 1,6, z). The certainty equivalent is that
amount of wealth such that the investor is indifferent between receiving it for
sure at the horizon, and having his current wealth today and the opportunity to
invest it optimally up to the horizon. Thus, the certainty equivalent is defined by

i (CE)Y= v(W, I, 66, T) = + W Yv(r, I, S, z).

Hence

CE(W , I, Z,6, z) = W [v(r, I, 6, T)] ‘ly .

‘sWith a short decision horizon, the objective function may be closely approximated by a function
which is quadratic in wealth and does not depend on the other state variables.
 M.J. Brennan et al. 1 Journal of Economic Dvnamics and Control 21 (1997) 1377- 1403 1399

0+ /
Jail-82 JGXb83 JBk84 Jan-85 JOlb-86 Jan-87 JaW88 JW-88 Jan-80 Jan-91 Jan-82

- CE(92) - - - - CE(lmth) - ~(92) -....-. w(,,,,th)

Fig. 10. The certainty equivalent wealth (CE) and realized wealth (w) under the optimal 1992
strategy (92) and the optimal 1 month strategy (lmth) when the portfolio proportions are not
constrained to be non-negative. The certainty equivalent is such that the investor is indifferent
between receiving it for sure at the horizon and having current wealth and the opportunity to invest
in the available opportunities up to the horizon.

Fig. 10 plots the certainty equivalents for the 1992 and the one-month
unconstrained strategies, where the latter is calculated by multiplying the
wealth realized under the one-month strategy by I?“‘, and u, which is computed
from the 1992 strategy, takes account of the value of the investment oppor-
tunities remaining till 1992. Fig. 10 shows strikingly that in the early years
the volatility of the certainty equivalent is much greater than the volatility
of wealth: in other words, most of the risk in the early years comes, not
from changes in wealth, but from changes in future investment prospects
as captured by the state variables. As the horizon is approached, variability
in the value of the investment opportunity set is correspondingly reduced.
Moreover, it is clear by inspection that the volatility of the certainty equi-
valent under the one-month strategy, which does not attempt to hedge against
shifts in the investment opportunity set, far exceeds the volatility of the
certainty equivalent under the 1992 strategy. Thus, the 1992 strategy,
as expected, does a better job of hedging against changes in the investment
opportunity set.
Fig. 11 plots zyxwvutsrqponmlkjihgfedcbaZYXWVUTSRQPONMLKJIHGFED
CE/W, the certainty equivalent per dollar of wealth for the
constrained (ce*) and unconstrained strategies (ce), along with the state vari-
ables. The normalized certainty equivalent, ce, is a measure of the value of the
1400 M.J. Brennan et al. /Journal ofEconomic Dynamics and Control 21 (1997) 1377-1403 zyxwvutsrqpon

16.00

14.00

12.00

10.00

8.W

6.00

4.w

2.00

0.00 -I tJ
Jan-82 Jail-83 JW-84 Jan-85 Jail-88 Jan-57 Jail-58 JOtiS JUl-80 Jan-91 Jan-92

Fig. 11. The normalized certainty equivalent wealth (ce = CE/w) under the optimal 1992 strategy
when the portfolio proportions are constrained to be non-negative (ce*) and are not constrained (ce).
The certainty equivalent is such that the investor is indifferent between receiving it for sure at the
horizon and having one dollar of wealth and the opportunity to invest in the available opportunities
up to the horizon. Also shown are the values of the state variables r, I and 6.

future investment opportunities for an investor with a given horizon and utility
function.24 Notice that in the early years the normalized certainty equivalent is
much greater for the unconstrained strategy, reflecting its ability to take more
advantage of investment opportunities by taking short positions; it is also more
sensitive to changes in the state variables. We also observe that the normalized
certainty equivalent tends to decline with time, reflecting the reduction in future
investment opportunities, eventually reaching unity at the horizon.
An investment strategy that hedges perfectly against changes in the invest-
ment opportunity set will ensure that zyxwvutsrqponmlkjihgfedcbaZYXWVUTSRQ
CE is constant. Since CE = ce W , this
would imply that the change in the log of ce was equal and opposite in sign to
the change in the log of W . To compare the hedging characteristics of the
unconstrained 1992 and one-month strategies the monthly change in the logar-
ithm of ce was regressed against the monthly change in the logarithm of wealth

24Note that the isoelastic utility function ensures that CE/W is independent of W.
 M.J. Brennan et al. /Journal of Economic Dynamics and Control 21 (1997) 1377-1403 1401

under the two strategies with the following results2’

dlnce = - 0.008 + 0.119 dln Wigg2, R2 = 0.02,

(2.89) (1.40)

dlnce = - 0.010 + 0.364 dln Wlmlh, R2 = 0.12.

(3.82) (3.95)

We note that while the change in lnce is positively related to the change in
In W under the one-month strategy, the relation is much less strong and is
statistically insignificant under the 1992 strategy: this is consistent with the
greater weight placed on hedging considerations under the 1992 strategy.
Fig. 11 clearly shows that the value of future investment opportunities is
significantly influenced by variation in the state variables that we have chosen to
capture investment opportunities; however, it is difficult to discern from the
figure the relative importance of the three state variables. To assess this, the
logarithm of the estimated value of ce for the constrained strategy was regressed
on the logarithms of the state variables and time to the horizon for each month
from January 1982 to December 1991:

In ce = - 0.578 - 0.152 In 6 - 0.157 lnr + 0.301 In 1 + 0.257 In z,

(2.24) (1.49) (3.53) (3.23) (21.56)

R2 = 0.87

ce is most strongly affected by the remaining time to maturity. It is increasing in

1, which is a direct measure of the favorableness of investment opportunities.
However, it is decreasing in r; this appears to be related to the fact that the
expected return on stock is negatively related to the short-term interest rate. On
the other hand, the dividend yield, which is positively related to the expected
return on stock does not enter the regression significantly. It should be noted
that the log-log specification of the regression is arbitrary.
While the results we have reported relate only to the single sample period,
1982-1991, they provide encouraging evidence that asset allocation strategies
designed to take account of time variation in expected returns can provide
significant performance improvement over static strategies, and comparison of
the 1992 strategy with the myopic one-month strategy points to the importance
of taking account of the investor’s time horizon in devising optimal portfolio
strategies.

‘%-Ratios in parenthesis.
1402 M.J. Brennan et al. 1 Journal of Economic @vamics and Control 21 (1997) 1377-1403

7. Conclusion

In this paper we have shown how it is possible to apply dynamic portfolio

theory to the design of optimal portfolio strategies for an investor with a long-
term horizon when there is time variation in the expected returns on different
asset classes. We find that the investor’s time horizon has a significant effect on
the composition of the optimal portfolio. An investor with a long horizon
typically places a larger fraction of the portfolio in both stocks and bonds than
does a myopic investor. The reason for this is the mean reversion in both bond
and stock returns that makes these assets less risky from the viewpoint of
a long-term investor. Equivalently, investments in stocks and, more particularly,
bonds provide the long-term investor with a hedge against future adverse shifts
in the investment opportunity set - by buying long-term bonds the investor
protects himself against declines in future interest rate. Myopic strategies such as
those commonly employed in simple tactical asset allocation implementations
neglect this role of long-term assets and misleadingly treat cash as a riskless
asset; in reality, cash is riskless only for an investor with a one-period horizon.26
The out of sample simulation results provide encouraging evidence that the
predictability of asset returns is sufficient for strategies that take it into account
to yield significant improvements in portfolio returns. In this paper we have
derived the optimal strategy assuming that the parameters of the return generat-
ing process are known rather than estimated. The next challenge is to extend the
scope of the analysis to take account of estimation risk. We anticipate that this
will reduce the tendency of the unconstrained model to take highly levered
portfolio positions and will reduce the implied portfolio turnover rates. Our
analysis takes account of only three asset classes. Extension to additional asset
classes is straightforward so long as the expected returns on these asset classes
can be expressed in terms of the same set of state variables. Extending the
analysis to incorporate additional state variables is straightforward in principle,
but significantly increases computational requirements.

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