Predictability-Robust Dynamic Portfolio Choice

37 Pages Posted: 20 Mar 2007

See all articles by Frank Lutgens

Frank Lutgens

Maastricht School of Business and Economics

Peter C. Schotman

Maastricht University - Department of Finance

Date Written: March 15, 2007

Abstract

Dynamic portfolio choice crucially depends on the predictability of returns. In contrast to its importance, confirmation of the existence of predictability is lacking. We consider a robust investor who arms herself against the adverse effects of uncertainty about predictability but also exploits the benefits of predictability insofar it is significant. We show that robust dynamic portfolio choice does not exhibit the extreme risky investment of traditional and Bayesian portfolios, is less volatile and features intertemporal hedging demands. We also show the worst plausible form of predictability for the robust portfolio result. This worst case depends on the horizon, initial state, the portfolio, and the relations among the predictor variables. For long term investment the worst case features a low long term average of the predictor variable and a high exposure to this low average.

Keywords: Robustness, Dynamic portfolio choice, model uncertainty, estimation

JEL Classification: C11, C44, D80

Suggested Citation

Lutgens, Frank and Schotman, Peter C., Predictability-Robust Dynamic Portfolio Choice (March 15, 2007). AFA 2008 New Orleans Meetings Paper, Available at SSRN: https://ssrn.com/abstract=972057 or http://dx.doi.org/10.2139/ssrn.972057

Frank Lutgens

Maastricht School of Business and Economics ( email )

P.O. Box 616
Maastricht, 6200 MD
Netherlands

Peter C. Schotman (Contact Author)

Maastricht University - Department of Finance ( email )

P.O. Box 616
Maastricht, 6200 MD
Netherlands
+31 43 388 3862 (Phone)
+31 43 388 4875 (Fax)

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