The Impact of Model Instability on Long-Term Investors

46 Pages Posted: 15 Aug 2014

See all articles by Bart F. Diris

Bart F. Diris

Erasmus University Rotterdam (EUR) - Department of Econometrics; Netspar

Date Written: August 13, 2014

Abstract

Should long-term investors account for time-variation in model parameters? We develop a time-varying Vector Autoregressive model that can handle time-variation in intercepts, slopes, volatility and correlation, the leverage effect in volatility and fat tails. Long-term investors should take time-variation in volatility and correlation into account due to its high persistence, but can safely ignore time-variation in slope coefficients and intercepts due to its low persistence. Modeling time-variation in parameters with a random walk specification or a specification that pools persistence across parameters leads to a large overestimation of the riskiness of stock returns and an underinvestment in the stock market.

Keywords: strategic asset allocation, Bayesian MCMC techniques, state space models, stochastic volatility, time-varying parameters

JEL Classification: G11, C11, C32, C58, C63

Suggested Citation

Diris, Bart Franciscus and Diris, Bart Franciscus, The Impact of Model Instability on Long-Term Investors (August 13, 2014). Available at SSRN: https://ssrn.com/abstract=2480046 or http://dx.doi.org/10.2139/ssrn.2480046

Bart Franciscus Diris (Contact Author)

Netspar ( email )

P.O. Box 90153
Tilburg, 5000 LE
Netherlands

Erasmus University Rotterdam (EUR) - Department of Econometrics ( email )

P.O. Box 1738
3000 DR Rotterdam
Netherlands

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