Keep it Simple: Dynamic Bond Portfolios Under Parameter Uncertainty
44 Pages Posted: 12 Mar 2012 Last revised: 16 Nov 2012
Date Written: March 5, 2012
We empirically investigate the importance of parameter uncertainty to bond investors. Using a Bayesian approach, we quantify the expected utility loss due to parameter uncertainty from following seemingly optimal dynamic portfolio strategies. Expected utility losses are increasing in the number of term structure factors and the complexity of the risk premium specification. Even with long data sets to estimate parameters, an investor with typical risk aversion is better off following a portfolio strategy implied by a misspecified but parsimonious model than a correctly-specified but difficult-to-estimate three-factor affine model with time-varying risk premia.
Keywords: Suboptimal investments, parameter uncertainty, utility losses, bond portfolios, MCMC estimation
JEL Classification: G11, G12, C13
Suggested Citation: Suggested Citation