To summarise, the effect on equities seems ambiguous to you, but it’s clearly negative on bonds, so investors would likely tilt towards equities.
“Negative for bonds” does not imply “shift investment from bonds to stocks”, though. It could mean “shift toward short bonds” or “shift investment from bonds, to just invest less overall”.
In addition, the sharpe ratio of the optimal portfolio is decreased (since one of the main asset classes is worse)
I would push back on this too, for a related reason—the optimal portfolio can include “go short bonds”, which might now have a higher expected return.
I think the standard asset pricing logic would be: there is one optimal portfolio, and you want to lever that up or down depending on your risk tolerance and how risky that portfolio is. So, whether you ‘take less total exposure to risky assets’ depends on whether the argument here updates your view on how ‘risky’ the future is (Tyler Cowen has argued this, I’m not sure it’s super clear cut though).
That makes sense. It just means you should decrease your exposure to bonds, and not necc buy more equities.
I’m skeptical you’d end up with a big bond short though—due to my other comment. (Unless you think timelines are significantly shorter or the market will re-rate very soon.)
I think the standard asset pricing logic would be: there is one optimal portfolio, and you want to lever that up or down depending on your risk tolerance and how risky that portfolio is.
In the merton’s share, your exposure depends on (i) expected returns of the optimal portfolio (ii) volatility / risk (iii) the risk free rate over your investment horizon and (iv) your risk aversion.
You’re arguing the risk free rate will be higher, which reduces exposure.
It seems like the possibility of an AI boom will also increase future volatility, also reducing exposure.
Then finally there’s the question of expected returns of the optimal portfolio, which you seem to think is ambiguous.
So it seems like the expected effect would be to reduce exposure.
“Negative for bonds” does not imply “shift investment from bonds to stocks”, though. It could mean “shift toward short bonds” or “shift investment from bonds, to just invest less overall”.
I would push back on this too, for a related reason—the optimal portfolio can include “go short bonds”, which might now have a higher expected return.
I think the standard asset pricing logic would be: there is one optimal portfolio, and you want to lever that up or down depending on your risk tolerance and how risky that portfolio is. So, whether you ‘take less total exposure to risky assets’ depends on whether the argument here updates your view on how ‘risky’ the future is (Tyler Cowen has argued this, I’m not sure it’s super clear cut though).
That makes sense. It just means you should decrease your exposure to bonds, and not necc buy more equities.
I’m skeptical you’d end up with a big bond short though—due to my other comment. (Unless you think timelines are significantly shorter or the market will re-rate very soon.)
In the merton’s share, your exposure depends on (i) expected returns of the optimal portfolio (ii) volatility / risk (iii) the risk free rate over your investment horizon and (iv) your risk aversion.
You’re arguing the risk free rate will be higher, which reduces exposure.
It seems like the possibility of an AI boom will also increase future volatility, also reducing exposure.
Then finally there’s the question of expected returns of the optimal portfolio, which you seem to think is ambiguous.
So it seems like the expected effect would be to reduce exposure.