The Role of Transaction Costs and Risk Aversion When Selecting Between One and Two Regimes for Portfolio Models

Abstract

Estimation errors in the inputs are the main problem when applying portfolio analysis, and Markov regime switching models have been shown to reduce these errors. We investigate whether the use of two regime models remains superior across a range of values of risk aversion and transaction costs, in the presence of skewness and kurtosis and no short sales. Our results for US data suggest that, due to differences in their risk preferences and transactions costs, most retail investors may prefer to use one regime models, while investment banks prefer to use two regime models.

Keywords: Portfolio theory; regime shifting; transaction costs; risk aversion; constant relative risk aversion

JEL Classification: G11