Asset allocation with differential borrowing and lending rates

Popular financial planning advice suggests that investors alter their asset allocation between stock, bonds, and cash to reflect risk tolerance. In contrast, Markowitz mean-variance efficiency shows that all investors should hold the market portfolio. Differences between theory and practice arise for three reasons. First, estimation of the efficient frontier is quite sensitive to the time period and asset classes chosen for mean-variance optimization. Second, even Treasury bills are not truly a risk free asset due to inflation. Finally, and most importantly, investors can only borrow at some rate higher than the risk free rate. This paper empirically investigates the impact of these problem areas on Markowitz optimal portfolios and shows that the popular advice is generally consistent with financial theory in a real-world environment. It makes sense for real-world investors to hold different portfolios that depend upon their levels of risk tolerance. Usually, but not always, investors wishing to take on more risk should increase their allocation of stocks relative to bonds.