Optimal Asset Allocation with Multivariate Bayesian Dynamic Linear Models

53 Pages Posted: 18 Oct 2018

See all articles by Carlos M. Carvalho

Carlos M. Carvalho

University of Texas at Austin - Red McCombs School of Business

Jared Fisher

University of Texas at Austin - Red McCombs School of Business

Davide Pettenuzzo

Brandeis University - Department of Economics

Date Written: September 25, 2018

Abstract

We introduce a simulation-free method to model and forecast multiple asset returns and employ it to investigate the optimal ensemble of features to include when jointly predicting monthly stock and bond excess returns. Our approach builds on the Bayesian Dynamic Linear Models of West and Harrison (1997), and it can objectively determine, through a fully automated procedure, both the optimal set of regressors to include in the predictive system and the degree to which the model coefficients, volatilities, and covariances should vary over time. When applied to a portfolio of five stock and bond returns, we find that our method leads to large forecast gains, both in statistical and economic terms. In particular, we find that relative to a standard no-predictability benchmark, the optimal combination of predictors, stochastic volatility, and time-varying covariances increases the annualized certainty equivalent returns of a leverage-constrained power utility investor by more than 500 basis points.

Keywords: Optimal Asset Allocation, Bayesian Econometrics, Dynamic Linear Models

JEL Classification: C11, C22, G11, G12

Suggested Citation

Carvalho, Carlos M. and Fisher, Jared and Pettenuzzo, Davide, Optimal Asset Allocation with Multivariate Bayesian Dynamic Linear Models (September 25, 2018). Available at SSRN: https://ssrn.com/abstract=3254935 or http://dx.doi.org/10.2139/ssrn.3254935

Carlos M. Carvalho

University of Texas at Austin - Red McCombs School of Business ( email )

Austin, TX 78712
United States

Jared Fisher

University of Texas at Austin - Red McCombs School of Business ( email )

Austin, TX 78712
United States

HOME PAGE: http://jareddf.github.io/

Davide Pettenuzzo (Contact Author)

Brandeis University - Department of Economics ( email )

Waltham, MA 02454-9110
United States
781.736.2834 (Phone)
781.736.2269 (Fax)

Register to save articles to
your library

Register

Paper statistics

Downloads
104
rank
254,347
Abstract Views
346
PlumX Metrics