Asset Allocation Under Multivariate Regime Switching

FRB of St. Louis Working Paper No. 2005-002C

41 Pages Posted: 28 Oct 2006

See all articles by Massimo Guidolin

Massimo Guidolin

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

Allan Timmermann

UCSD ; Centre for Economic Policy Research (CEPR)

Multiple version iconThere are 2 versions of this paper

Date Written: October 2006

Abstract

This paper studies asset allocation decisions in the presence of regime switching in asset returns. We find evidence that four separate regimes - characterized as crash, slow growth, bull and recovery states - are required to capture the joint distribution of stock and bond returns. Optimal asset allocations vary considerably across these states and change over time as investors revise their estimates of the state probabilities. In the crash state, buy-and-hold investors allocate more of their portfolio to stocks the longer their investment horizon, while the optimal allocation to stocks declines as a function of the investment horizon in bull markets. The joint effects of learning about state probabilities and predictability of asset returns from the dividend yield give rise to a non-monotonic relationship between the investment horizon and the demand for stocks. Welfare costs from ignoring regime switching can be substantial even after accounting for parameter uncertainty. Out-of-sample forecasting experiments confirm the economic importance of accounting for the presence of regimes in asset returns.

Keywords: regime switching, portfolio choice, predictability

JEL Classification: G12, G11, C32

Suggested Citation

Guidolin, Massimo and Timmermann, Allan, Asset Allocation Under Multivariate Regime Switching (October 2006). FRB of St. Louis Working Paper No. 2005-002C, Available at SSRN: https://ssrn.com/abstract=940652 or http://dx.doi.org/10.2139/ssrn.940652

Massimo Guidolin (Contact Author)

Bocconi University, Dept. of Finance ( email )

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Milan, MI 20136
Italy

Bocconi University - CAREFIN - Centre for Applied Research in Finance

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Milan, 20136
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Allan Timmermann

UCSD ( email )

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

Centre for Economic Policy Research (CEPR)

London
United Kingdom

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