It has, for example, been documented that risk premia and expected returns vary over time. An implication of this is that the Mossin-Merton-Samuelson result is incompatible with market clearing. The risks associated with a portfolio with a constant proportion of bonds and equities might be very different from what was previously understood. A framework to analyse the expected returns and risks associated with a dynamic rebalancing regime must be based on models that account for investors’ risk preferences and time-varying risk premia.
Analytical frameworks based on recursive risk preferences, long-run risk and time-varying volatility give a rationale for a dynamic rebalancing regime where different investors put different weights on different risk factors, such as short-run risk, long-run risk and volatility. Investor “preference heterogeneity” should not be interpreted literally as heterogeneity in “preferences”, but rather as reduced-form representations of other forms of heterogeneity associated with, for example, market frictions or market incompleteness.