Optimal Goals-Based Investment Strategies For Switching Between Bull and Bear Markets

Abstract

We apply dynamic programming to solve a long-horizon fund choice problem, given that the underlying market can switch between different regimes. The objective function is based on reaching a target level of wealth, following the paradigm of goal-based investing. In a world with a good regime (e.g., a bull market) and a bad regime (e.g., a bear market), we find that an investor who is cognizant of regime switching can potentially do much better over time than an investor who assumes there is only one regime. However, there is a caveat---an investor must be able to predict the regime they are in with reasonable levels of confidence, and if not, they are in fact worse off than an investor who assumes just one regime. Using data from recent history, we find that investors may be better off not switching from existing single-regime models to more complex multiple-regime models.

Keywords: Regimes, goals-based investing, dynamic optimization, uncertainty

JEL Classification: G02, G11