Optimal Portfolio Choice Under Regime Switching, Skew and Kurtosis Preferences

34 Pages Posted: 15 Jun 2003

See all articles by Allan Timmermann

Allan Timmermann

UCSD ; Centre for Economic Policy Research (CEPR)

Massimo Guidolin

Bocconi University, Dept. of Finance; Bocconi University - CAREFIN - Centre for Applied Research in Finance

Abstract

This paper proposes a new tractable approach to solving multi-period asset allocation problems. We assume that investor preferences are defined over moments of the terminal wealth distribution such as its skew and kurtosis. Time-variations in investment opportunities are driven by a regime switching process that can capture bull and bear states. We develop analytical methods that only require solving a small set of difference equations and thus are very convenient to use. These methods are applied to a simple portfolio selection problem involving choosing between a stock index and a risk-free asset in the presence of bull and bear states in the return distribution. If the market is in a bear state, investors increase allocations to stocks the longer their time horizon. Conversely, in bull markets it is optimal for investors to decrease allocations to stocks the longer their investment horizon.

Keywords: Optimal Asset Allocation, Regime Switching, Skew and Kurtosis Preference

Suggested Citation

Timmermann, Allan and Guidolin, Massimo, Optimal Portfolio Choice Under Regime Switching, Skew and Kurtosis Preferences. Available at SSRN: https://ssrn.com/abstract=406720 or http://dx.doi.org/10.2139/ssrn.406720

Allan Timmermann

UCSD ( email )

9500 Gilman Drive
La Jolla, CA 92093-0553
United States
858-534-0894 (Phone)

HOME PAGE: http://rady.ucsd.edu/people/faculty/timmermann/

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Massimo Guidolin (Contact Author)

Bocconi University, Dept. of Finance ( email )

Via Roentgen, 1
2nd floor
Milan, MI 20136
Italy

Bocconi University - CAREFIN - Centre for Applied Research in Finance

Via Sarfatti 25
Milan, 20136
Italy