Buy-and-Hold and Constant-Mix

May Be Better Allocation

Strategies Than You Think
Thomas J. O’Brien

T homas J. O’Brien
is a professor of finance
in the School of Business
at the University of
Connecticut in Storrs, CT.
thomas.obrien@uconn.edu
KEY FINDINGS
• Given mean-reverting equity and uncertain interest rates, investors sacrifice little in
expected utility by replacing the optimal reallocation strategy with a simpler allocation
strategy of either buy-and-hold or constant-mix.
• Traditional investors, with positive allocations to both equity and fixed income, are
better off with constant-mix than with buy-and-hold and with allocating to a horizon-
maturity fixed-income instrument rather than a sequence of single-period fixed-income
instruments.
• More risk-tolerant investors with levered equity positions are better off with buy-and-hold
than with constant-mix and with levering by a sequence of single-period fixed-income
instruments instead of a horizon-maturity fixed-income instrument.

*All articles are now
categorized by topics
and subtopics. View at
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ABSTRACT: Given mean-reverting equity and
interest rate uncertainty, this article shows a rela-
tively low economic cost of using a simple allocation
strategy, buy-and-hold or constant-mix, instead of
optimal reallocation. Moreover, given the decision
to use one of the simple allocation strategies, the
article identifies (1) which investors will be better
off with buy-and-hold than with constant-mix, and
vice versa, and (2) which investors will be better
off with a horizon-maturity fixed-income posi-
tion than with a sequence of short-maturity ones,
and vice versa. The article uses illustrations in a
three-period binomial model to bridge the academic/
practitioner gap and provide useful insights to those
interested in applied investment management.
TOPICS: Portfolio management/multi-
asset allocation, portfolio theory, portfolio
construction*
T
his article shows that with mean-
reverting equity and uncertain
interest rates, an investor can replace
the relatively complex optimal
allocation strategy with a simple one, either
buy-and-hold or constant-mix, with little
sacrifice in expected utility. The article also
shows that for some investors, buy-and-hold
is better than constant-mix, and a horizon-
maturity fixed-income position is better than
rolling a short-maturity one; the opposite
holds for other investors. The analysis uses
accessible illustrations in a three-period bino-
mial model. The objective is to bridge the
academic/practitioner gap and provide useful
insights to investment managers and applied
researchers.

Multi-Asset Special Issue 2020 The Journal of Portfolio Management   159

BACKGROUND AND OVERVIEW
Practitioners have typically argued that inves-
tors should allocate more to equity for longer horizons
because of the perceived benefit of time diversification.
In contrast, the academic position for many years was
that allocation should be myopic—that is, the same for
any horizon length. This position was based on the classic
Samuelson (1969)–Merton (1969) model, which assumes
the following: (1) equity follows a random walk; (2) the
risk-free rate is constant; (3) investors optimally reallo-
cate every period; and (4) investors’ utility is indepen-
dent of wealth (constant relative risk aversion [CRRA]).
However, Samuelson (1991) reconciled with
the practitioner perspective by formally showing that
if equity is mean reverting and the other Samuelson
(1969)–Merton (1969) assumptions hold, investors
with typical risk aversion levels will optimally allocate
more to equity for longer horizons. The horizon effect
is due to hedging unexpected changes in investment
opportunities, as described by Merton (1973).1 Other
horizon effect allocations have been identified in models
with unexpected changes in other investment oppor-
tunity variables, such as the uncertain risk-free rate
models of Sørensen (1999), Brennan and Xia (2000),
and Omberg (1999).2
In horizon effect models, investors’ optimal allo-
cations change through time. For example, in Samu-
elson’s (1991) mean-reverting equity model, investors
optimally reduce (raise) the equity allocation as equity
rises (drops). As a result, the optimal initial allocations
and reallocations are relatively difficult for investment
managers to determine and implement in actual practice.
Two other allocation strategies, buy-and-hold and con-
stant-mix, are suboptimal but simpler to apply than the
optimal reallocation strategy. Both simple strategies have
non-myopic optimal initial allocations that are easier
1
 Lee (1990) also defended the practitioner perspective, based
on an empirical analysis supporting equity mean reversion instead
of a random walk. A summary of empirical support for equity mean
reversion is given by Campbell et al. (2001). For additional research
with equity mean reversion and a constant risk-free rate, see Kim
and Omberg (1996), Campbell and Viceira (1999), Barberis (2000),
Campbell et al. (2001), and Wachter (2002).
2
 Horizon effect models like those of Campbell and Viceira
(2002a), Campbell et al. (2003), Munk, Sørensen, and Vinther
(2004), and Liu (2007) investigate dynamic allocation given multiple
investment opportunity variables.
160   Buy-and-Hold and Constant-Mix May Be Better Allocation Strategies Than You Think Multi-Asset Special Issue 2020
Exhibit 1
Summary of Insights into Mean-Reverting Equity
and Uncertain Risk-Free Rate
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to find than the optimal reallocation strategy’s. Going
forward, both simple strategies are obviously easier to
maintain than the optimal reallocation strategy; buy-
and-hold requires no additional effort beyond finding
the initial allocation, and constant-mix involves only
rebalancing each period to the initial allocation.
This article compares the buy-and-hold and
constant-mix strategies with each other and with the
optimal reallocation strategy. Following the approach of
Kritzman (1994, 2015), the comparisons use three-period
binomial model illustrations with reasonable assumptions
for the equity risk premium, equity volatility, and
the risk-free rate. Investors allocate between mean-
reverting equity and a risk-free fixed-income instru-
ment. Instead of a constant risk-free rate (e.g., Samuelson
1991; Kritzman 1994, 2015; Barberis 2000; and others),
this article assumes that the short-term risk-free rate
depends on market conditions and is therefore uncer-
tain. This assumption permits a comparison between
short-term and long-term instruments for an investor’s
fixed-income allocation. Such a comparison is impos-
sible with a constant risk-free rate, in which a sequence
of single-period risk-free instruments is equivalent to a
zero-coupon instrument with a longer time to maturity.
The illustrations yield the following interesting
insights, which are brief ly summarized in Exhibit 1.
First, the economic cost of using either simple strategy
in lieu of optimal reallocation is relatively low. The
measure of cost is the additional initial wealth needed
to make a simple strategy’s expected utility of horizon
wealth equal to that of the optimal reallocation strategy,
as done by Larsen and Munk (2012).
 Second, an investor’s optimal simple allocation Exhibit 2
strategy depends on whether the investor is a traditional Equity Price Dynamics
investor, who makes positive allocations to both equity
and fixed income, or a more risk-tolerant investor, who 7LPH    
holds a levered equity position. Traditional investors are 
better off with a constant-mix strategy than with buy- 
and-hold. In contrast, more risk-tolerant investors with  
levered equity positions are better off with a buy-and-  
hold strategy than with constant-mix.  

Third, although optimal reallocators are indif-

ferent about a fixed-income allocation to short- or long-
term instruments, this is not the case for investors using
one of the simple allocation strategies. For either simple
strategy, traditional investors are better off allocating to
Exhibit 3
Equity Mean-Reversion Dynamics
a horizon-maturity fixed-income instrument instead of
a sequence of short-term ones, and more risk-tolerant, 7LPH    
levered investors are better off using a sequence of short- 
term instruments instead of a long-term one. 
 
FRAMEWORK FOR THE ANALYSIS 
  
Investors allocate wealth between equity and  
a fixed-income position. Here, investors may choose    
between two approaches to the fixed-income position.  
   
In the bills approach, the fixed-income position uses a
 
rolling sequence of single-period risk-free instruments.   
In the horizon-maturity approach, the fixed-income 
position is a zero-coupon instrument with maturity  
equal to the investment horizon. 
Given the allocation strategy, an investor allocates 
to maximize the expected utility of horizon wealth.
The analysis uses traditional power utility functions of
the form U = 1 - W 1-b, where W is horizon wealth and The bottom half of the tree has the same structure.
b denotes the degree of CRRA. Guo and Whitelaw At time 0 and at any point in the middle of the tree,
(2006) indicated that power utility describes empirical the probability of moving up (down) is 0.50 (0.50), and
data fairly well and that the average investor’s CRRA the single-period expected equity return is 9% with a
is higher than 1. standard deviation of 15%. As Exhibit 3 shows in the
For the equity, each up-state (down-state) is 1.24 boxes, the single-period expected equity return drops
(0.94) times the prior period’s realized value (dividends (rises) as the equity price rises (drops). Exhibit 3 shows
reinvested), as shown in the three-period binomial tree the up- and down-state probabilities between the times.3
in Exhibit 2.
To illustrate mean reversion, the probability of 3
 The assumed up- and down-state probability structure is
an up-state in the top half of the tree is assumed to arbitrary and selected because the resulting risk-free rate and equity
risk premium dynamics (in Exhibit 4) seem reasonable. This simple
be lower than that of an immediately preceding up-
approach to mean reversion in a binomial framework is sufficient
state. For example, after an up-state with a probability for the three-period illustrations here. Researchers investigating
of 0.50, the probability of a repeat up-state is 0.4333, mean-reversion effects for longer horizons may find the methods of
that of a third consecutive up-state is 0.376, and so on. Nelson and Ramaswamy (1990) and Hahn and Dyer (2008) helpful.

Multi-Asset Special Issue 2020 The Journal of Portfolio Management   161

Exhibit 4
Risk-Free Rate and Equity Risk Premium Dynamics
Time: 0 1 2 3
1.375%
2.14% 3.14%
3% 4% 3%
4% 5% 4% 5%
5% 6% 5%
5.86% 6.86%
6.625%
The time-0 single-period risk-free rate is 4%, and
thus the time-0 equity risk premium is 5%.4 A change
in the expected equity return implies the same change
in the equity risk premium if the risk-free rate is con-
stant and the same change in the risk-free rate if the
equity risk premium is constant. Neither of these two
extreme cases seems reasonable because in reality both
the risk-free rate and the equity risk premium f luctuate
with market conditions. Therefore, this analysis uses an
intermediate setting in which a change in the expected
equity return is ref lected in equal changes in both the
risk-free rate and the equity risk premium. For example,
if the expected equity return drops by 200 bps, the risk-
free rate and the equity risk premium each drop by
100 bps. Exhibit 4 shows the binomial tree dynamics
for the short-term risk-free rate (outside the boxes) and
the equity risk premium (inside the boxes).
The uncertainty in the short-term risk-free rate
implies an upward-sloping yield curve for longer-term
risk-free instruments. The yield-to-maturity of a two-
period (three-period) zero-coupon instrument is 4.16%
(4.30%). This yield curve occurs because longer-term
instruments are redundant and may be engineered via
a no-arbitrage dynamic replication using equity and
single-period instruments.5 For example, consider a
4
 The 4% short-term risk-free rate is not too far from the
long-run average three-month Treasury rate (http://pages.stern
.nyu.edu/~adamodar/New_Home_Page/datafile/histretSP.html).
The equity risk premium of 9% - 4% = 5% is slightly below the
historical average (same site), but it is in line with ex ante estimates
(e.g., Welch 2009).
5
 Equity is used in the replication because the framework
is a single-factor one, in which equity innovations drive the risk-
free rate innovations. Given this simple one-factor framework, the
periodic rate of return on multiperiod fixed-income instruments is
162   Buy-and-Hold and Constant-Mix May Be Better Allocation Strategies Than You Think Multi-Asset Special Issue 2020
two-period zero-coupon instrument that pays 100 at
time 2 regardless of which state occurs. This instrument
becomes a single-period one at time 1. The time-1 up-
state (down-state) risk-free rate of 3% (5%) implies the
instrument’s time-1 price is 100/1.03 = 97.09 (100/1.05 =
2.375%
95.24). These time-1 prices may be replicated by a time-0
4%
investment of 6.164 in equity and 86.004 in the single-
period risk-free instrument yielding 4%. Therefore,
6% the time-0 no-arbitrage price of the two-period, zero-
coupon instrument is 6.164 + 86.004 = 92.17, implying
7.625% a compound yield-to-maturity of (100/92.17) 0.50 -
1 = 0.0416, or 4.16% per period. By a similar process,
the time-0 yield-to-maturity on a three-period, zero-
coupon instrument is 4.30% per period.6
For the optimal reallocation strategy, the solution
involves finding the optimal allocations for each state at
the last time before the horizon and then working back-
ward using trial and error to find the optimal alloca-
tions for all states at each time, until finding the optimal
time-0 allocation. For the bills approach, this process
results in the following solution for an investor with
b = 4: time-2 equity allocations of 41.9% in the up-state,
61.7% in the mid-state, and 84.0% in the down-state;
time-1 equity allocations of 58.2% in the up-state and
81.4% in the down-state; and a time-0 equity allocation
of 77.2%. The buy-and-hold and constant-mix strategies
are much easier because they only involve solving for
the optimal time-0 allocation directly by trial and error
using several equations for horizon wealth.7
positively correlated with equity returns. This feature is consistent
with the positive empirical correlation found by Viceira (2012).
Although the integration of fixed-income and equity markets is a
reasonable assumption, the connection between fixed-income and
equity returns here is admittedly a considerable simplification of the
story by Viceira (2012), especially regarding business cycle effects.
6
 The replication of the three-period instrument, going for-
ward, starts at time 0 with 100/1.04303 = 88.13, which is allocated
11.02 to equity and 77.11 to the single-period instrument yielding 4%.
The time-1 up-state (down-state) outcome is 93.86 (90.56). Real-
locate at the time-1 up-state (down-state) to 5.83 in equity and
88.03 in a single-period instrument (5.63 in equity and 84.93 in a
single-period instrument). The time-2 outcomes are 97.90, 96.15,
and 94.46 in the up-, mid-, and down-state, respectively. At time
2, reallocate to 100% in the single-period instrument and collect
100 regardless of the state outcome at time 3.
7
 Equations for the two-period horizon wealth for each
strategy are shown in the Appendix. These equations are sufficient
to help clarify the computational details for the interested reader.
The equations for the three-period horizon wealth are analogous
but are longer and more numerous.
Exhibit 5
Optimal Initial Equity Allocations: Three-Period Horizon

Bills Approach Horizon-Maturity Approach

Single- Optimal Buy-and- Constant- Optimal Buy-and- Constant-
b Period Reallocation Hold Mix Reallocation Hold Mix

1.50 1.703 1.817 1.818 1.808 1.934 1.871 1.859

2 1.262 1.406 1.408 1.383 1.464 1.432 1.405
2.50 1.001 1.155 1.146 1.123 1.177 1.152 1.129
3 0.829 0.986 0.966 0.948 0.984 0.960 0.943
3.50 0.708 0.864 0.836 0.823 0.845 0.822 0.809
4 0.617 0.772 0.739 0.729 0.739 0.718 0.709
4.50 0.547 0.701 0.663 0.655 0.658 0.637 0.630
5 0.491 0.642 0.602 0.596 0.591 0.573 0.568
6 0.408 0.557 0.511 0.508 0.494 0.476 0.473
8 0.305 0.450 0.398 0.397 0.371 0.355 0.355
10 0.243 0.385 0.330 0.330 0.297 0.283 0.284
12 0.202 0.342 0.286 0.286 0.248 0.235 0.237

ALLOCATION RESULTS a buy-and-holder’s with the horizon-maturity approach

For degrees of risk aversion ranging from b = 1.50
to b = 12, Exhibit 5 summarizes the optimal initial
equity allocations of the three strategies for the three-
period horizon. For comparison purposes, Exhibit 5 first
shows the optimal single-period equity allocation, for
which there is no distinction among the three strate-
gies. The next three columns show the optimal initial
equity allocations for the three strategies for the bills
approach to the fixed-income allocation. The last three
columns show the optimal initial equity allocations for
the horizon-maturity approach to the fixed-income
allocation.
For both the bills and horizon-maturity approaches,
Exhibit 5 shows several patterns among the initial equity
allocations of the three strategies. First, all three strate-
gies involve the horizon effect of allocating more to
equity for the three-period horizon than for the single-
period horizon, regardless of the degree of risk aversion.
Second, an optimal reallocator’s initial equity alloca-
tion tends to be higher than that of a buy-and-holder
or a constant-mixer. The only exceptions are that an
optimal reallocator’s initial equity allocation is slightly
lower than a buy-and-holder’s with the bills approach
for b = 1.5 or 2. Third, a buy-and-holder’s optimal ini-
tial equity allocation tends to be higher than that of a
constant-mixer. The only exceptions are that a constant-
mixer’s initial equity allocation is slightly higher than
for b = 10 or 12.
Despite these observed patterns, practical invest-
ment managers might not regard the three strategies’
allocations as being hugely different, especially for the
horizon-maturity approach. For example, for b = 4 for
the horizon-maturity approach, the allocations shown
(shaded) in Exhibit 5 are as follows: for optimal real-
location, 73.9% (with 26.1% to the three-period zero-
coupon instrument); for buy-and-hold, 71.8% (with
28.2% to the three-period zero-coupon instrument);
and for constant-mix, 70.9% (with 29.1% to the three-
period zero-coupon instrument). For b = 4 for the bills
approach, the allocations (shaded) are as follows: for
optimal reallocation, 77.2% (with 22.8% to the single-
period instrument); for buy-and-hold, 73.9% (with 26.1%
to the single-period instrument); and for constant-mix,
72.9% (with 27.1% to the single-period instrument).
The Economic Cost of the Simple
Allocation Strategies
By definition, optimal reallocation is the best
strategy (in terms of expected utility of horizon wealth)
for either the bills or horizon-maturity approaches to the
fixed-income allocation. Following Larsen and Munk
(2012), this study quantifies the cost of each simple
strategy as the percentage of initial wealth that would
result in the same expected utility of horizon wealth

Multi-Asset Special Issue 2020 The Journal of Portfolio Management   163

Exhibit 6
Cost (%) of Simple Strategies versus Optimal Reallocation: Three-Period Horizon

Bills Approach Horizon-Maturity Approach

Buy-and-Hold Constant-Mix Buy-and-Hold Constant-Mix
b Equity Cost (%) Equity Cost (%) Equity Cost (%) Equity Cost (%)
1.50 1.818 0.03% 1.808 0.27% 1.871 0.05% 1.859 0.28%
2 1.408 0.09% 1.383 0.21% 1.432 0.11% 1.405 0.21%
2.50 1.146 0.14% 1.123 0.18% 1.152 0.15% 1.129 0.18%
3 0.966 0.17% 0.948 0.15% 0.960 0.17% 0.943 0.15%
3.50 0.836 0.18% 0.823 0.14% 0.822 0.17% 0.809 0.13%
4 0.739 0.18% 0.729 0.13% 0.718 0.17% 0.709 0.12%
4.50 0.663 0.19% 0.655 0.12% 0.637 0.16% 0.630 0.10%
5 0.602 0.19% 0.596 0.11% 0.573 0.16% 0.568 0.09%
6 0.511 0.19% 0.508 0.10% 0.476 0.15% 0.473 0.08%
8 0.398 0.18% 0.397 0.10% 0.355 0.13% 0.355 0.06%
10 0.330 0.19% 0.330 0.10% 0.283 0.11% 0.284 0.05%
12 0.286 0.19% 0.286 0.11% 0.235 0.09% 0.237 0.04%

as the optimal reallocation strategy. Trading costs of Buy-and-Hold versus Constant-Mix

reallocating/rebalancing are not considered in the cost
estimates.
The results are shown in Exhibit 6. For the bills and
horizon-maturity approaches for each simple strategy,
Exhibit 6 shows the initial equity allocations (again, for
convenience) and the percentage cost of the strategy.
Overall, the cost of either simple strategy seems
relatively small. For example, assume an initial wealth
of $1. For b = 4 with the bills approach, the buy-and-
hold strategy has an initial equity allocation of 73.9%;
with initial wealth of $1.0018, the expected utility of
horizon wealth is equal to that of the optimal realloca-
tion strategy. Therefore, Exhibit 6 shows that the buy-
and-hold strategy’s cost is 0.18%, or $1.80 per $1,000
invested. The constant-mix strategy has an initial equity
allocation of 72.9%, and with initial wealth of $1.0013,
the expected utility of horizon wealth is equal to that of
the optimal reallocation strategy. Therefore, Exhibit 6
shows the constant-mix strategy’s cost is 0.13%, or $1.30
per $1,000 invested.
Exhibit 6 shows that as risk aversion increases, the
buy-and-hold strategy’s cost tends to rise at first for both
fixed-income approaches and then level-off for the bills
approach and drop for the horizon-maturity approach.
In contrast, the constant-mix strategy’s cost tends to
drop as risk aversion increases for both fixed-income
approaches.
Exhibit 6 shows that the economic cost for the
buy-and-hold strategy tends to be lower than that for
the constant-mix strategy for levered investors (with
initial equity allocations greater than 100%) and higher
than that for the constant-mix strategy for traditional
investors (with positive initial fixed-income allocations).
These findings should interest investment managers
and applied researchers because they imply that buy-
and-hold is superior to constant-mix for levered inves-
tors, but constant-mix is superior to buy-and-hold for
traditional investors, as indicated by the boldfacing in
Exhibit 6 of the initial equity allocations with the higher
expected utility of horizon wealth.
These findings are due to the difference between
the two simple strategies’ expectations and dispersion of
horizon wealth. First, think about an investor with an
initial equity allocation of 100%. For this allocation, the
buy-and-hold and constant-mix strategies are the same
and therefore have the same expected wealth, dispersion
of wealth, and expected utility of wealth. For a tradi-
tional investor with positive allocations in both equity
and fixed income, the expected horizon wealth is higher
with the buy-and-hold strategy than with the constant-
mix strategy, but so is the dispersion of horizon wealth
outcomes. For example, for b = 4 for the bills approach,
the optimal buy-and-hold (constant-mix) strategy has an
expected horizon wealth of 1.244 (1.242) with a standard

164   Buy-and-Hold and Constant-Mix May Be Better Allocation Strategies Than You Think Multi-Asset Special Issue 2020
deviation of 0.197 (0.188). Because of this traditional
investor’s relatively high aversion to dispersion risk, the
constant-mix strategy yields a higher expected utility
of wealth than the buy-and-hold strategy, even though
buy-and-hold has the higher expected horizon wealth.8
For an investor with a levered equity allocation,
the dispersion of horizon wealth outcomes is lower with
the buy-and-hold strategy than with the constant-mix
strategy. For example, for b = 2 for the bills approach,
the optimal buy-and-hold (constant-mix) strategy has an
expected horizon wealth of 1.352 (1.350) with a stan-
dard deviation of 0.389 (0.399). With a higher expected
horizon wealth and a lower dispersion, the buy-and-hold
strategy gives a higher expected utility of horizon wealth
than the constant-mix strategy.
Bills versus Horizon-Maturity
Approach to Fixed-Income Allocation
Exhibit 6 shows that for each of the three allocation
strategies, the optimal initial equity allocation is higher
for the bills approach than for the horizon-maturity
approach for traditional investors holding positive allo-
cations in both equity and fixed income but is higher
for the horizon-maturity approach than for the bills
approach for investors with a levered equity allocation.
This observed pattern may be understood by first
noting that optimal reallocators are indifferent between
the bills and horizon-maturity approaches. The two
approaches yield the same expected utility of horizon
wealth because the f lexible reallocations can embed a
dynamic replication of a long-term risk-free instrument
via a combination of equity and a sequence of single-
period risk-free instruments, as described in the pre-
vious section. This feature is due to the simplicity of the
one-factor framework used here; more general models
(e.g., Sørensen 1999) suggest that a horizon-maturity
bond is the best hedge of changes in future investment
opportunities. Here, optimal reallocators will have the
same effective equity allocation for either fixed-income
approach, despite having a higher actual equity allo-
cation with the bills approach when the fixed-income
8
 Constant-mix has a higher horizon wealth outcome in states
that result from the most reversals, consistent with the Perold and
Sharpe (1995) illustrations for an investor with a constant mix of
60% equity and 40% bills.
Multi-Asset Special Issue 2020
allocation is positive and with the horizon-maturity
approach when the fixed-income allocation is negative.9
Both simple allocation strategies have the same
general pattern as optimal reallocation: The equity
allocation is higher for the bills approach than for the
horizon-maturity approach for traditional investors
(those with positive allocations to fixed income) and is
higher for the horizon-maturity approach than for the
bills approach for levered investors. The primary source
of the pattern is again that a three-period fixed-income
instrument can be replicated by a dynamic combination
of equity and single-period risk-free instruments.
However, because the simple strategies do not
involve the f lexibility to embed the dynamic replica-
tion in the allocations, the bills and horizon-maturity
approaches yield a different maximum expected utility
of horizon wealth. Based on the economic cost estimates
in Exhibit 6 for both simple strategies, the horizon-
maturity approach results in a higher expected utility
of horizon wealth for the more risk-averse traditional
investors, who make positive allocations to both equity
and fixed income. The bills approach yields a higher
expected utility of horizon wealth for the more risk-
tolerant investors with levered equity allocations.
For the two simple strategies, the better of the bills
and horizon-maturity approaches is indicated by the
shading in Exhibit 6 of the initial equity allocations for
the simple strategy with lower economic cost and thus
higher expected utility of horizon wealth.
The explanation for these results is that the risk in
the framework, which is driven by the uncertainty of
the equity prices, is priced into long-term fixed-income
instrument yields for the degree of risk aversion of a
representative investor, who holds a 100% equity alloca-
tion. Buy-and-holders and constant-mixers who allo-
cate less than 100% to equity, and are thus more risk
averse than a representative investor, find it a bargain to
use the horizon-maturity instrument instead of single-
period instruments for their fixed-income allocation.
9
 The initial equity allocations for the bills and horizon-matu-
rity approaches are therefore related. Letting B and H be the respec-
tive initial equity allocations for the bills and horizon-maturity
approaches and R be the ratio of the initial equity allocation to the
single-period instrument allocation for the synthetic three-period
fixed-income instrument, the relationship between H and B is
H = B(1 + R) - R. For example, consider b = 4, where B = 0.772 and
H = 0.739. Using numbers from footnote 6, R = 0.1102/0.7711 =
0.1429. Thus, H = 0.772(1.1429) - 0.1429 = 0.739.
The Journal of Portfolio Management   165
Buy-and-holders and constant-mixers who allocate
more than 100% to equity, and are thus less risk averse
than a representative investor, find it better to lever
with a sequence of single-period instruments and avoid
overpaying for leverage by borrowing with a long-term
instrument.10
The fixed-income allocation findings are inter-
esting and may be useful to investment managers. It is
natural to ask whether the results are generalizable to
richer models than the single-factor one used here. That
remains for future research to determine, but in any
model there should be a difference between the expected
utility of horizon wealth for the bills and horizon-
maturity approaches for the two simple allocation
strategies. The reason is that the simple strategies do not
permit investors to embed the replication of a long-term
fixed-income instrument into the allocations.
Summary: Optimal Alternatives for the
Simple Allocation Strategies
For traditional investors, who allocate less than
100% to equity, the previous subsections establish that
the constant-mix strategy is better than the buy-and-
hold strategy, and the horizon-maturity approach is
better than the bills approach. Therefore, constant-mix
with the horizon-maturity approach is the best of the
four simple strategy alternatives for traditional investors.
Similarly, for levered investors, who allocate more than
100% to equity, the buy-and-hold strategy is better than
the constant-mix strategy, and the bills approach is better
than the horizon-maturity approach. Therefore, the
buy-and-hold strategy with the bills approach is the best
of the four simple strategy alternatives for levered inves-
tors. The boldface, shaded outcomes in Exhibit 6 indi-
cate these optimal simple allocation strategy alternatives.
10
 The lending by traditional investors and the borrowing by
levered investors must net to zero. This model feature defines the
representative investor as one with an equity allocation of 100%.
Theoretical models of multiperiod equilibrium (e.g., Rubinstein
1981) feature only optimal reallocators. Nevertheless, a model that
formally includes buy-and-holders and constant-mixers would
retain the restriction that the net of all lending and borrowing is
zero, and thus the representative investor would have an equity
allocation of 100%. Note that balancing demand for long-term
lending by traditional constant-mixers and short-term borrowing
by levered buy-and-holders would be reconciled by viewing the
long-term fixed-income instrument as a synthetic combination of
equity and the short-term instrument.
166   Buy-and-Hold and Constant-Mix May Be Better Allocation Strategies Than You Think Multi-Asset Special Issue 2020
COMPARISON WITH OTHER BASE CASES
How do the study’s main results, presented in the
previous section, compare to those for two other base
cases: (1) the classic model in which equity follows a
random walk and the risk-free rate is constant and (2) the
Samuelson (1991) case in which equity is mean reverting
and the risk-free rate is constant?
First, if equity follows a random walk and the
risk-free rate is constant, the constant-mix strategy is
optimal, and so the economic cost of using this simple
strategy is zero. In this classic model, Jagannathan and
Kocherlakota (1996), Barberis (2000), and Campbell and
Viceira (2002b, p. 26) indicated that buy-and-holders
have horizon effects, but the effects are practically negli-
gible for typical equity risk premium and volatility levels.
Therefore, the economic cost of using the buy-and-hold
strategy is negligible in the random-walk setting with a
constant risk-free rate.11 In general, the economic cost
of using a simple allocation strategy is zero or negligible
in the classic model case.
Next, consider the case in which equity is mean
reverting and the risk-free rate in constant. This is the
case developed by Samuelson (1991) and illuminated
by Kritzman (1994, 2015). An important distinction
between this case and the uncertain risk-free rate case
presented earlier is that the yield curve is f lat with a
constant risk-free rate, and there is no effective distinc-
tion between the bills and horizon-maturity approaches
to fixed-income allocation.
Exhibit 7 shows the three-period optimal initial
allocations for the three strategies when the risk-free rate
is a constant 4%. The bold numbers in Exhibit 7 indi-
cate a finding like that in Exhibit 6: that constant-mix
is better than buy-and-hold for investors with positive
fixed-income allocations, and buy-and-hold is better
than constant-mix for investors with levered equity
positions.
One can see in Exhibit 7 the Samuelson (1991)
horizon effect that an optimal reallocator with b > 1
allocates more to mean-reverting equity for a longer
horizon if the risk-free rate is constant. Samuelson (1991)
and Barberis (2000) explained that optimal realloca-
tors hold more in mean-reverting equities for longer
11
 Van Eaton and Conover (1998) showed nonnegligible buy-
and-hold horizon effects in the classic model, which are due to
an unusually high equity volatility assumption of 54% per period.
Exhibit 7 is constant (uncertain). However, the differences are of
Optimal Initial Equity Allocations: Three-Period a similar order of magnitude. Therefore, the economic
Horizon and Constant Risk-Free Rate cost of using the buy-and-hold strategy is roughly the
same for the certain and uncertain risk-free rate cases.
Single- Optimal Buy-and- Constant- Exhibit 7 also shows that constant-mixers allocate
b Period Reallocation Hold Mix more to mean-reverting equity for longer horizons if the
1.5 1.703 1.852 1.994 1.852 risk-free rate is constant. As for buy-and-holders, con-
2 1.262 1.430 1.532 1.434 stant mixers’ initial equity allocation is higher (lower)
2.5 1.001 1.162 1.235 1.168
than optimal reallocators’ when the risk-free rate is con-
3 0.829 0.977 1.029 0.984
stant (uncertain). However, the differences are much
3.5 0.708 0.843 0.881 0.850
4 0.617 0.742 0.770 0.748
smaller for the constant risk-free rate case than for the
4.5 0.547 0.661 0.683 0.668 uncertain risk-free rate case. Therefore, the economic
5 0.491 0.596 0.614 0.603 cost of using the constant-mix strategy is higher in the
6 0.408 0.499 0.510 0.505 uncertain risk-free rate case than in the constant risk-
8 0.305 0.375 0.380 0.381 free rate case.
10 0.243 0.301 0.303 0.306 The economic cost of using a simple allocation
12 0.202 0.251 0.252 0.255 strategy when equity is mean reverting is thus generally
a bit higher if the risk-free rate is uncertain rather than
constant. Nevertheless, this article’s main point is that
horizons (if b > 1) to hedge the uncertainty in future
the cost is relatively modest even in the more realistic
investment opportunities in the sense of Merton (1973).
case in which interest rates are uncertain.
The optimal reallocators’ initial equity allocations
These interesting comparisons of the allocations
in Exhibit 7 are lower than those in Exhibit 5 for tradi-
for the constant and uncertain risk-free rate cases may be
tional investors, with positive initial fixed-income allo-
leads for future applied research seeking a deeper under-
cations (b ≥ 3), and are higher than those in Exhibit 5 for
standing of dynamic allocation strategies. This study’s
levered investors (b ≤ 2.5). The explanation is that the
binomial model with three periods is a starting point
traditional investors’ hedging demand is higher when the
that keeps the analysis manageable and accessible. Future
risk-free rate is uncertain and the Bills approach is used
research may be able to shed more light on the issues
than if the risk-free rate is constant; for levered optimal
by extending the analysis to more periods. However,
reallocators, the opposite holds.
modeling equity mean reversion in a binomial frame-
In contrast, the optimal reallocators’ initial equity
work with more periods is more difficult. Perhaps fur-
allocations in Exhibit 7 are relatively close to those in
ther progress is possible using techniques such as Monte
Exhibit 5 for the horizon-maturity approach. The reason
Carlo or block bootstrapping simulation, or approaches
is that the three-period risk-free instrument has a risky
like those by Nelson and Ramaswamy (1990) and Hahn
component that is effectively like equity, as explained
and Dyer (2008).
earlier. Thus, some of the hedging demand when the
risk-free rate is uncertain is met with the fixed-income
allocation if the horizon-maturity approach is used. CONCLUSION
Exhibit 7 also shows that buy-and-holders allocate
Recent academic models of dynamic allocation for
more to mean-reverting equity for longer horizons if the
mean-reverting equity show that a higher equity alloca-
risk-free rate is constant, consistent with the buy-and-
tion is optimal for a longer horizon for an investor with
hold horizon effect identified by Kritzman (1994, 2015)
a typical level of risk aversion who optimally reallocates
and Barberis (2000). Barberis (2000) explained that buy-
through time. Equity mean reversion has substantial
and-holders view mean-reverting equity as cumulatively
empirical support, but the dynamic optimal reallocation
less risky for longer horizons, and so they allocate more
strategy is relatively difficult for real-world investors to
to equity for longer horizons than for shorter horizons.
implement. This article therefore investigates the useful-
Buy-and-holders’ initial equity allocation is higher
ness of two strategies that are easier to apply: buy-and-
(lower) than optimal reallocators’ when the risk-free rate
hold and constant-mix.

Multi-Asset Special Issue 2020 The Journal of Portfolio Management   167

 The study uses three-period binomial illustrations time-0 equity allocation for the two-period horizon is deter-
of allocating between mean-reverting equity and a fixed- mined by first finding the optimal time-1 equity allocations
income position when the risk-free rate is uncertain. for the up- and down-states, w 1u and w 1d, and then working
The illustrations use reasonable assumptions for the risk- backwards to find the w 0 that maximizes the expected utility
free rate, the equity risk premium, and equity volatility. of time-2 horizon wealth, given w 1u and w 1d.
The goal is to develop insights that may be useful to
investment managers and applied researchers. Bills Approach
The following interesting findings are potentially
useful to investment managers. (1) The economic cost For the bills approach, the possible two-period horizon
wealth outcomes of an investor are shown in Equations A1a
of using a simpler strategy is relatively small when mea-
to A1d for a buy-and-holder, in Equations A2a to A2d for a
sured in terms of the wealth equivalent of the loss in
constant-mixer, and in Equations A3a to A3d for an optimal
the expected utility of horizon wealth versus that of the reallocator. The outcome probabilities are 0.2167, 0.2833,
optimal reallocation strategy; investment managers who 0.2833, and 0.2167, respectively.
prefer using a simple strategy may find these results reas-
suring. (2) Traditional investors, who have positive allo-
Buy-and-Holder
cations to both equity and fixed income, would prefer a
constant-mix strategy to a buy-and-hold strategy and a [1.5376w 0 + (1 + 0.04)(1 + 0.03)(1 – w 0 )] (A1a)
horizon-maturity fixed-income position to a sequence
of single-period fixed-income positions. (3) More risk- [1.1656w 0 + (1 + 0.04)(1 + 0.03)(1 – w 0 )] (A1b)
tolerant investors with levered equity positions would
prefer a buy-and-hold strategy to a constant-mix strategy
[1.1656w 0 + (1 + 0.04)(1 + 0.05)(1 – w 0 )] (A1c)
and a sequence of single-period fixed-income positions
to a horizon-maturity position.
[0.8836w 0 + (1 + 0.04)(1 + 0.05)(1 – w 0 )] (A1d)
As with academic models of optimal reallocation,
this article also finds that for either buy-and-hold or
constant-mix, a typical investor’s optimal equity alloca- Constant-Mixer
tion is higher for a longer horizon. Interestingly, the buy-
and-hold and constant-mix strategies tend to involve [1.24w 0 + (1 + 0.04)(1 – w 0 )] ⋅ [1.24w 0 + (1 + 0.03)(1 – w 0 )]

lower optimal initial equity allocations than an optimal (A2a)
reallocator’s if the risk-free rate is uncertain, but the
reverse holds if the risk-free rate constant. This horizon [1.24w 0 + (1 + 0.04)(1 – w 0 )] ⋅ [0.94w 0 + (1 + 0.03)(1 – w 0 )]

effect finding may be of interest to applied researchers. (A2b)

Although this article uses a reasonable set of
assumptions, a caveat is that findings based on illustra- [0.94w 0 + (1 + 0.04)(1 – w 0 )] ⋅ [1.24w 0 + (1 + 0.05)(1 – w 0 )]

tions are not necessarily general. A further limitation is
(A2c)
the use of only three periods. Nevertheless, the results
are interesting and may be useful to future researchers [0.94w 0 + (1 + 0.04)(1 – w 0 )] ⋅ [0.94w 0 + (1 + 0.05)(1 – w 0 )]
in developing more general models and investigating (A2d)
longer horizons.

Optimal Reallocator
Appendix
[1.24w 0 + (1 + 0.04)(1 – w 0 )] ⋅ [1.24w1u + (1 + 0.03)(1 – w1u )]
The Appendix shows equations for two-period horizon
(A3a)
wealth assuming a time-0 wealth of 1. The optimal time-0
equity allocation percentage is denoted w 0. The solutions
[1.24w 0 + (1 + 0.04)(1 – w 0 )] ⋅ [0.94w1u + (1 + 0.03)(1 – w1u )]
for w 0 for a buy-and-holder and a constant-mixer are found
using straightforward trial and error. An optimal reallocator’s (A3b)

168   Buy-and-Hold and Constant-Mix May Be Better Allocation Strategies Than You Think Multi-Asset Special Issue 2020
 [0.94w 0 + (1 + 0.04)(1 – w 0 )] ⋅ [1.24w1d + (1 + 0.05)(1 – w1d )] Optimal Reallocator

(A3c)
[1.24w 0 + (1 + 0.0534)(1 – w 0 )] ⋅ [1.24w1u + (1 + 0.03)(1 – w1u )]

(A6a)
[0.94w 0 + (1 + 0.04)(1 – w 0 )] ⋅ [0.94w1d + (1 + 0.05)(1 – w1d )]
(A3d)
[1.24w 0 + (1 + 0.0534)(1 – w 0 )] ⋅ [0.94w1u + (1 + 0.03)(1 – w1u )]
(A6b)
Horizon-Maturity Approach
  [0.94w 0 + (1 + 0.0333)(1 – w 0 )] ⋅ [1.24w1d + (1 + 0.05)(1 – w1d )]
For the horizon-maturity approach, the possible out- (A6c)
comes for horizon wealth of an investor with a two-period
horizon are shown in Equations A4a to A4c for a buy-and-
[0.94w 0 + (1 + 0.0333)(1 – w 0 )] ⋅ [0.94w1d + (1 + 0.05)(1 – w1d )]
holder, in Equations A5a to A5d for a constant-mixer, and in
(A6d)
Equations A6a to A6d for an optimal reallocator.
As shown in the text, the yield-to-maturity of a two-
period, zero-coupon risk-free instrument is 4.16%. For a ACKNOWLEDGMENTS
two-period constant-mixer or reallocator using the horizon-
maturity approach, the two-period instrument’s period-1 Thanks to Carmelo Giaccotto, Chris Piros, and an
rates of return are 0.0534 (= 97.09/92.17 - 1) and 0.0333 anonymous reviewer for helpful comments and suggestions.
(= 95.24/92.17 - 1), using prices shown in the text.
The outcome probabilities for Equations A4a to A4c
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 ADDITIONAL READING

Buy and Hold Versus Timing Strategies:

The Winner Is …
Todd Feldman, A lan Jung, and Jim K lein
The Journal of Portfolio Management 
https://jpm.pm-research.com/content/42/1/110
ABSTRACT: The authors propose three simple market-timing
strategies and compare them to other commonly known strategies, such
as the yield curve, earnings yield vs. Treasury yield, Shiller CAPE,
and S&P 500 200-day simple moving average. The first strategy
uses the leading economic indicator (LEI) from the Conference Board.
The other two use sentiment indexes from the Baker-Wurger index
and the Feldman perceived loss index to trigger the switch between the
S&P 500 and three-month Treasury bills. The Conference Board’s
LEI strategy earns the highest return of the three strategies, beating
the benchmark strategy, which consists of simply holding the S&P
500, by 1.66% per year from 1970 to 2012. Corresponding monthly
returns are significantly different from those of the benchmark strategy
at the 10% level. The authors also combine strategies and find that a
mix of both fundamental and technical strategies produces even greater
returns than does any single market timing strategy. The combina-
tion of the Conference Board LEI and S&P 500 200-day moving
average beats the benchmark strategy by 2.76% annually. Lastly, they
find that the Shiller CAPE underperforms all of the market-timing
strategies in question, as well as the S&P 500 benchmark strategy.

Multi-Asset Special Issue 2020 The Journal of Portfolio Management   171

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