Choices Under Uncertainty and the Investment Horizon

Mean-Variance is the most popular investment rule employed by both practitioners and researches. For a short-planned investment horizon, this rule generally conforms with expected utility paradigm. However, for a relatively long horizon, generally more than one year, the distributions of returns become positively skewed, hence the M-V rule loses ground. As the horizon increases, by the M-V rule one needs (mistakenly) to increase the weight of bonds in the stock-bond portfolio, e.g., almost 100% in bonds for a 30-year horizon. This is in contrast to expected utility maximization recommending almost 100% in stocks for long horizons. This gap is of crucial importance, because life expectancy is increasing, implying longer investment horizons. For long horizons the mean-coefficient-of-variation (M-C) rule conforms with expected utility, as the distributions are close to log-normal. For intermediate horizons one should employ stochastic dominance (SD) or direct expected utility maximization.