Optimal portfolio choice in real terms: Measuring the benefits of TIPS

In this paper we solve an optimal portfolio choice problem to measure the benefits of Treasury Inflation Indexed Securities (TIPS) to investors concerned with maximizing real wealth. We show how the introduction of a real riskless asset completes the investor asset space, by contrasting optimal portfolio allocations with and without such assets. We use historical data to quantify gains from availability of TIPS in the presence of other asset classes such as equities, commodities, and real estate. We draw a distinction between buy-and-hold long-term investors for whom TIPS fully displace nominal risk-free assets and short-term investors for whom TIPS improve the investment opportunity set of real returns. Finally, we show how gains from TIPS are tempered by the availability of alternative assets that covary with inflation, such as gold and real estate.

► We measure the empirical benefits that TIPS provide to investors.
► We differentiate investors according to their investment horizon.
► Short-term investors devote a fraction of their wealth to TIPS.
► The benefits to short-term investors diminish when they have a wider investment opportunity set.
► Long-term investors replace nominal bonds with TIPS for all levels of relative risk aversion.