Empirical results based on two different statistical approaches lead to several conclusions about the role of time-varying asset risk assessments in accounting for what, on the basis of many earlier studies, appear to be time-varying differentials in ex ante asset returns. First, both methods indicate sizeable changes over time in variance-covariance structures conditional on past information. These changing conditional variance-covariance structures in turn imply sizeable changes over time in asset demand behavior, and hence in the market-clearing equilibrium structure of ex ante asset returns. Second, at least for some values of the parameter indicating how rapidly investors discount the information contained in past observations, the implied ex ante excess returns bear non-negligible correlation to observed ex post excess returns on either debt or equity. The percentage of the variation of ex post excess returns explained by the implied time-varying ex ante excess returns is comparable to values to which previous researchers have interpreted as warranting rejection of the hypothesis that risk premia are constant over time. Third, although for long-term debt the two statistical methods used here give sharply different answers to the question of how much relevance market participants associate with past observations in assessing future risks, for equities both methods agree in indicating extremely rapid discounting of more distant observations -- so much so that in neither case do outcomes more than a year in the past matter much at all. While the paper's other conclusions are plausible enough, the finding of such an extremely short "memory" on the part of equity investors suggests that the standard representation of equity risk by a single normally distributed disturbance is overly restrictive

In this second collection of his writings on financial markets (the first, On Exchange Rates, covered international finance), Jeffrey Frankel turns his attention to domestic markets, with special attention to how national monetary policy is handled. The decade of the 1980s left many central bankers disillusioned with monetarism, so that the question of the optimal nominal anchor remains an open one. In this second collection of his writings on financial markets (the first, On Exchange Rates, covered international finance), Jeffrey Frankel turns his attention to domestic markets, with special attention to how national monetary policy is handled. The fifteen papers are divided into three sections, each introduced by the author. They cover, respectively, optimal portfolio diversification, indicators of expected inflation, and the determination of monetary policy in the face of uncertainty. In the first section, Frankel explores what information the theory of optimal portfolio diversification can give the macroeconomist. In the second section, he considers what economic variables central bankers might use to gauge whether monetary policy is too tight or too loose. And in the final section, he looks at the range of uncertainty over policy effects and how that complicates coordination of macroeconomic policymaking. The book concludes with a sympathetic analysis of nominal GDP targeting.

Academic finance has had a remarkable impact on many financial services. Yet long-term investors have received curiously little guidance from academic financial economists. Mean-variance analysis, developed almost fifty years ago, has provided a basic paradigm for portfolio choice. This approach usefully emphasizes the ability of diversification to reduce risk, but it ignores several critically important factors. Most notably, the analysis is static; it assumes that investors care only about risks to wealth one period ahead. However, many investors—-both individuals and institutions such as charitable foundations or universities—-seek to finance a stream of consumption over a long lifetime. In addition, mean-variance analysis treats financial wealth in isolation from income. Long-term investors typically receive a stream of income and use it, along with financial wealth, to support their consumption. At the theoretical level, it is well understood that the solution to a long-term portfolio choice problem can be very different from the solution to a short-term problem. Long-term investors care about intertemporal shocks to investment opportunities and labor income as well as shocks to wealth itself, and they may use financial assets to hedge their intertemporal risks. This should be important in practice because there is a great deal of empirical evidence that investment opportunities—-both interest rates and risk premia on bonds and stocks—-vary through time. Yet this insight has had little influence on investment practice because it is hard to solve for optimal portfolios in intertemporal models. This book seeks to develop the intertemporal approach into an empirical paradigm that can compete with the standard mean-variance analysis. The book shows that long-term inflation-indexed bonds are the riskless asset for long-term investors, it explains the conditions under which stocks are safer assets for long-term than for short-term investors, and it shows how labor income influences portfolio choice. These results shed new light on the rules of thumb used by financial planners. The book explains recent advances in both analytical and numerical methods, and shows how they can be used to understand the portfolio choice problems of long-term investors.

An investor’s risk attitude is a stable characteristic, like a personality trait, but risk-taking behavior can change based on the investor’s age, recent market events, and life experiences. These factors change investors’ perceptions of the risks. Differences in risk tolerance between men and women or in different circumstances trace back to emotional as much as rational considerations. Financial advisers should consider all of these factors when advising clients and can use four simple steps to incorporate best practices: be aware, educate, nudge, and hand hold.