Disasters, Large Drawdowns, and Long-term Asset Management

52 Pages Posted: 11 Jun 2021 Last revised: 21 Jun 2021

See all articles by Eric Jondeau

Eric Jondeau

University of Lausanne - Faculty of Business and Economics (HEC Lausanne); Swiss Finance Institute

Alexandre Pauli

University of Lausanne - School of Economics and Business Administration (HEC-Lausanne); Swiss Finance Institute

Date Written: June 8, 2021

Abstract

Long-term investors are often reluctant to invest in assets or strategies that can suffer from large drawdowns. A major challenge for such investors is to gain access to predictions of large drawdowns in order to precisely design strategies minimizing these drawdowns. In this paper, we describe a multivariate Markov-switching model framework that allows us to predict large drawdowns. We provide evidence that three regimes are necessary to capture the negative trends in expected returns that generate large drawdowns, and we correctly predict conditional drawdowns. In addition, investment strategies based on these models outperform model-free strategies based on the empirical distribution of drawdowns. These results hold within and out of the sample.

Keywords: Large drawdowns, Stock-market returns, Markov-switching model, Portfolio allocation model

JEL Classification: C53, G15

Suggested Citation

Jondeau, Eric and Pauli, Alexandre, Disasters, Large Drawdowns, and Long-term Asset Management (June 8, 2021). Swiss Finance Institute Research Paper No. 21-37, Available at SSRN: https://ssrn.com/abstract=3864263 or http://dx.doi.org/10.2139/ssrn.3864263

Eric Jondeau (Contact Author)

University of Lausanne - Faculty of Business and Economics (HEC Lausanne) ( email )

Extranef 232
Lausanne, 1012
Switzerland
+41 21 692 33 49 (Phone)

HOME PAGE: http://people.unil.ch/ericjondeau/

Swiss Finance Institute

c/o University of Geneva
40, Bd du Pont-d'Arve
CH-1211 Geneva 4
Switzerland

Alexandre Pauli

University of Lausanne - School of Economics and Business Administration (HEC-Lausanne) ( email )

Unil Dorigny, Batiment Internef
Lausanne, 1015
Switzerland

Swiss Finance Institute ( email )

c/o University of Geneva
40, Bd du Pont-d'Arve
CH-1211 Geneva 4
Switzerland

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