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Should the proportion of risky assets in the risky part of an investor's portfolio depend on the investor's risk aversion? According to basic financial theory, in particular the mutual-fund separation theorem with a riskless asset, the answer is no. The theorem states that rational investors should divide their assets between a riskless asset and a risky mutual fund, the composition of which is the same for all investors. Risk aversion affects only the allocation between the riskless asset and the fund.
However, Niko Canner et al. (1997), CMW hereafter, observed that popular investment advice does not conform to this theory. They reported the stocks, bonds, and cash allocations recommended by four advisors for conservative, moderate, and aggressive investors. As shown in Table 1, which is reproduced from CMW, the advisors recommend a bond/stock ratio that varies directly with risk aversion. For example, Fidelity recommends a bond/stock ratio of 1.50 for a "conservative" (more riskaverse) investor, a ratio of 1.00 for a "moderate" (less risk-averse) investor, and a ratio of 0.46 for an "aggressive" (still less risk-averse) investor. The inconsistency between such advice and the separation theorem is called an asset allocation puzzle by CMW. They attempted to solve the puzzle by relaxing key assumptions in the theory, but finally reached a negative conclusion: "Although we cannot rule out the possibility that popular advice is consistent with some model of rational behavior, we have so far been unable to find such a model" (p. 181). However, they suggested that consideration of intertemporal trading might help resolve the puzzle.
In the present paper, we provide theoretical support for the popular advice. The two key insights are that the investor's horizon may exceed the maturity of the cash asset and that the investor rebalances the portfolio as time...