Stock returns and inflation risk: Implications for portfolio selection

This paper focuses on the exposure of common stocks to inflation risk and assesses the impact of this exposure on portfolio choice. We show that the relation between real stock returns and inflation rates, as well as the parameter uncertainty involved with this relation, hassubstantial influence on optimal asset allocations. During the 1985 – 2010 period, inflation risk induces a typical long-term investor to allocate up to 40 percentage points less of his wealth to stocks, as compared to a benchmark investor who believes that stocks are not exposed to inflation risk. The benchmark investor generally overstates expected stock returns and/or understates return volatility, resulting in too high stock allocations

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