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Forthcoming 2023

Policy Instability and the Risk-Return Trade-Off

by Rodolfo E. Manuelli and Jose Martinez-Gutierrez


What is the impact of large swings in economic policy on the risk-return trade-off faced by investors? What is the impact of changes in policy regimes on investment strategies? In this paper we study the impact on returns of switches between periods of market-friendly economic policies and periods of populist policies. To quantify the impact of policy instability, we use data from Argentina—a country that has experienced frequent and very large regime changes—and find that the risk-return for individual assets and minimum variance portfolios are quite different across regimes. We then develop a dynamic model to understand optimal portfolios when investors are cognizant that regimes can change. We find that when portfolios are unrestricted, it is optimal for investors to take a large amount of risk. On the other hand, when portfolios are restricted to include only long positions, a real asset (real estate) dominates financial assets.

Rody Manuelli is a professor of economics at Washington University in St. Louis and a research fellow at the Federal Reserve Bank of St. Louis. Jose Martinez-Gutierrez is a PhD candidate at Washington University in St. Louis. The authors are extremely grateful to Santiago Mosquera and Federico Sturzenegger for sharing their data and helping them understand the construction of the different series. An anonymous referee provided very useful comments that helped the authors better analyze the original question.


Over the last few years, many countries have adopted economic policies that can be broadly defined as populist. Typically, these policies include different forms of interventions that disrupt market mechanisms. The impact of a given policy is determined by, not only its features, but also its stability. Policy regimes that change very frequently create uncertainty and negatively affect investment decisions. The historical records of many Latin American economies show that many have experienced frequent switches between (relatively) market-friendly and populist regimes, and some view these changes as imposing significant costs.

A country's economic performance depends crucially on its ability to direct savings to the most productive uses. Economic policies have a large impact on how investors choose to allocate their savings. In this paper we document how the risk-return trade-off faced by an investor changes with the policy regime and we illustrate how portfolios that perform well in one regime can generate large losses when the regime changes. We then develop a model of dynamic portfolio selection to study how a rational investor should choose his portfolio, accounting for the possibility of regime changes and the costs—both in terms of time and resource—of adjusting the portfolio.

To illustrate the forces at work, we study the impact of policy instability in Argentina, a country characterized by frequent and dramatic swings in economic policies. We use monthly data on the real returns on a collection of assets that include time deposits (both fixed and adjustable rate), real estate, and foreign exchange (US dollar) at both the official exchange rate—which is typically controlled by the government during populist periods—and the black market rate that is easily accessible to individual investors. The sample period is from 1981 to 2019 and includes four populist periods and three market periods.

We find that  the risk-return trade-off using the full sample—which corresponds to the appropriate approach if one ignores regime changes—is very misleading of the actual options available to investors. If we allow for unrestricted portfolios—that is, portfolios in which some assets can be shorted—the minimum variance frontier during market periods uniformly dominates that of populist periods. This means that for a given riskiness of the portfolio, expected returns are higher during the market regime.

This finding, somewhat surprisingly, depends crucially on the assumption that the investor can go short in some assets. In the case of Argentina, the returns on investing in foreign exchange are negative during market periods and positive during populist periods. Thus, a policy of contracting debts in US dollars during market periods is behind the large returns of the optimal portfolio. This result is roughly consistent with the observation that Argentina has, in the past, significantly increased borrowing in foreign currency during market periods. It also shows that high returns are associated with leverage and the regime-dependent returns encourage even risk-averse investors to take significant risk by highly leveraging their portfolios.

To capture the trade-offs faced by investors that cannot short any asset, we compute the minimum variance frontier, imposing the restriction that no asset can be used to borrow to finance long positions. The results are radically different. Two extreme observations give a good sense of the differences. First, the safest (lowest variance) portfolio that can be constructed using returns during the populist period has a level of risk—as measured by the standard deviation of the returns—that is about 50 percent higher than the riskiest portfolio during the market period. Second, the highest expected return that is possible to attain in the market regime falls short of 9 percent, while the portfolio with the highest expected return in the populist period earns over 60 percent per year.

To better understand optimal investment decisions, we develop a dynamic portfolio choice model. We consider a long-lived investor who understands that regime changes are stochastic and that it is costly—both in terms of time and resources—to adjust a portfolio. We consider several scenarios and find that the composition of the optimal portfolio depends, crucially, on whether assets can be shorted or not. In the case that the investor can borrow, they take advantage of this possibility by creating high return-high risk portfolios during market regimes by borrowing in foreign exchange and investing in domestic real estate. The negative positions are undone during populist regimes to reduce the riskiness of the portfolio, but investments in real estate are still a major component.

These large differences in the composition of the optimal portfolios are a reflection of the large differences in returns across policy regimes. These differences imply that a fixed portfolio, apart from one invested in real estate, that performs well in one regime can earn poor returns upon a regime change.

A more general, although somewhat speculative, message from our exercise is that policy instability that is associated with increased uncertainty will generally induce large changes in positions and hence in the price of different assets. Even though Argentina is an extreme example of poor and unstable policy, it is a perfect laboratory to study the potential costs of instability as they appear to be large.

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