Policy Instability and the Risk-Return Trade-Off

Rodolfo E. Manuelli and Jose Martinez-Gutierrez
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Jose Martinez-Gutierrez: https://economics.wustl.edu/people/jose-martinez-gutierrez

Review, 2024, vol. 106, issue 2, 106-128

Abstract: What is the impact of large swings in economic policy on the risk-return trade-off faced by investors? What is the impact of changes in policy regimes on investment strategies? In this paper we study the impact on returns of switches between periods of market-friendly economic policies and periods of populist policies. To quantify the impact of policy instability, we use data from Argentina—a country that has experienced frequent and very large regime changes—and find that the risk-return for individual assets and minimum variance portfolios are quite different across regimes. We then develop a dynamic model to understand optimal portfolios when investors are cognizant that regimes can change. We find that when portfolios are unrestricted, it is optimal for investors to take a large amount of risk. On the other hand, when portfolios are restricted to include only long positions, a real asset (real estate) dominates financial assets.

Keywords: economic policy; policy instability; risk-return trade-off; investment strategies (search for similar items in EconPapers)
JEL-codes: E44 G11 G12 (search for similar items in EconPapers)
Date: 2024
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Persistent link: https://EconPapers.repec.org/RePEc:fip:fedlrv:97555

DOI: 10.20955/r.106.106-28

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