Consumption and portfolio decisions when expected returns are time varying

This paper presents an approximate analytical solution to the optimal consu mption and portfolio choice problem of an infinitely lived investor with Ep stein-Zin-Weil utility who faces a constant riskless interest rate and a ti me-varying equity premium. When the model is calibrated to U.S. stock marke t data, it implies that intertemporal hedging motives greatly increase, and may even double, the average demand for stocks by investors whose risk-ave rsion coefficients exceed one. The optimal portfolio policy also involves t iming the stock market. Failure to time or to hedge can cause large welfare losses relative to the optimal policy.