Expected Utility Maximization and Time Diversification

Abstract

Time diversification continues to be a subject of intense debate within investment and academic communities. Among practitioners it not unusual to find the recommendation that an investor with a long investment horizon, should tilt the portfolio weights towards stocks. In this study, we analyze if the portfolio weights for stocks and bills, which are formed on the basis of direct expected utility maximization for a set of utility functions, vary significantly with the investment horizon. We use a non-parametric bootstrap approach, which allow us to draw inference about the optimal weights for different investment horizons. Through this approach we are also able to study the effect of estimation risk. Our analysis shows that investors with long investment horizons should invest more heavily in stocks, that is, we find that the weights for stocks are significantly higher for long horizon investment as compared to the one-year horizon. We conclude that time diversification exists, and that the allocation decision seems to be independent of the utility function.