The bond-stock mix under time-varying interest rates and predictable stock returns

- This paper investigates bond-stock investments under predictable stock returns.
- Optimal asset allocation is affected by the condition of the economy.
- In an undervalued stock market, the optimal bond-stock ratio increases in time.
- At the investment horizon, the bond-stock ratio is independent of risk aversion.

I investigate the allocation of wealth to cash, bonds, and stocks, along with the bond-to-stock ratio (BSR) when interest rates are time-varying and stock returns are predictable via the dividend-price ratio (DPR). The bond-stock mix and the BSR vary with the deviation of the current level of the DPR from its long-run mean and the correlations between all asset classes. The BSR may decrease over time, which contradicts both previously reported results on the matter as well as popular advice. Finally, I show that it is only at the investment horizon that the BSR is independent of risk aversion.