Policy Instability and the Risk-Return Trade-Off

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.