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Predictable Returns and Asset Allocation: Should a Skeptical Investor Time the Market?

Jessica A. Wachter

University of Pennsylvania - Finance Department; National Bureau of Economic Research (NBER)

Missaka Warusawitharana

Federal Reserve Board - Board of Governors

August 16, 2005

AFA 2006 Boston Meetings Paper

Are excess returns predictable and if so, what does this mean for investors? Previous literature has tended toward two polar viewpoints: that predictability is useful only if the statistical evidence for it is incontrovertible, or that predictability should affect portfolio choice, even if the evidence is weak according to conventional measures. This paper models an intermediate view: that both data and theory are useful for decision-making. We investigate optimal portfolio choice for an investor who is skeptical about the amount of predictability in the data. Skepticism is modeled as an informative prior over the improvement in the Sharpe ratio generated by using the predictor variable. We find that the evidence is sufficient to convince even an investor with a highly skeptical prior to vary his portfolio on the basis of the dividend-price ratio and the yield spread. The resulting weights are less volatile, and, as we show, deliver superior out-of-sample performance compared with weights implied by diffuse priors, dogmatic priors, and ordinary least squares regression.

Number of Pages in PDF File: 53

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Date posted: March 19, 2005  

Suggested Citation

Wachter, Jessica A. and Warusawitharana, Missaka, Predictable Returns and Asset Allocation: Should a Skeptical Investor Time the Market? (August 16, 2005). AFA 2006 Boston Meetings Paper. Available at SSRN: http://ssrn.com/abstract=687535 or http://dx.doi.org/10.2139/ssrn.687535

Contact Information

Jessica A. Wachter (Contact Author)
University of Pennsylvania - Finance Department ( email )
The Wharton School
3620 Locust Walk
Philadelphia, PA 19104
United States
215-898-7634 (Phone)
215-898-6200 (Fax)

National Bureau of Economic Research (NBER)
1050 Massachusetts Avenue
Cambridge, MA 02138
United States
Missaka Warusawitharana
Federal Reserve Board - Board of Governors ( email )
20th Street and Constitution Avenue NW
Washington, DC 20551
United States
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References:  48
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