Predictable Returns and Asset Allocation: Should a Skeptical Investor Time the Market?

62 Pages Posted: 27 Jun 2007 Last revised: 28 Aug 2007

See all articles by Jessica A. Wachter

Jessica A. Wachter

University of Pennsylvania - Finance Department; National Bureau of Economic Research (NBER)

Missaka Warusawitharana

Board of Governors of the Federal Reserve System

Multiple version iconThere are 2 versions of this paper

Date Written: June 2007

Abstract

Are excess returns predictable and if so, what does this mean for investors? Previous literature has tended toward two polar viewpoints: that predictability is useful only if the statistical evidence for it is incontrovertible, or that predictability should affect portfolio choice, even if the evidence is weak according to conventional measures. This paper models an intermediate view: that both data and theory are useful for decision-making. We investigate optimal portfolio choice for an investor who is skeptical about the amount of predictability in the data. Skepticism is modeled as an informative prior over the R^2 of the predictive regression. We find that the evidence is sufficient to convince even an investor with a highly skeptical prior to vary his portfolio on the basis of the dividend-price ratio and the yield spread. The resulting weights are less volatile and deliver superior out-of-sample performance as compared to the weights implied by an entirely model-based or data-based view.

Suggested Citation

Wachter, Jessica A. and Warusawitharana, Missaka, Predictable Returns and Asset Allocation: Should a Skeptical Investor Time the Market? (June 2007). NBER Working Paper No. w13165, Available at SSRN: https://ssrn.com/abstract=993067

Jessica A. Wachter (Contact Author)

University of Pennsylvania - Finance Department ( email )

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National Bureau of Economic Research (NBER)

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Missaka Warusawitharana

Board of Governors of the Federal Reserve System ( email )

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