Asset Allocation Under Multivariate Regime Switching

Posted: 16 Jan 2008

See all articles by Allan Timmermann

Allan Timmermann

UCSD ; Centre for Economic Policy Research (CEPR)

Massimo Guidolin

Bocconi University, Dept. of Finance; Bocconi University - CAREFIN - Centre for Applied Research in Finance

Multiple version iconThere are 2 versions of this paper

Date Written: January 12, 2008

Abstract

This paper studies asset allocation decisions in the presence of regime switching in asset returns. We find evidence that four separate regimes - characterized as crash, slow growth, bull and recovery states - are required to capture the joint distribution of stock and bond returns. Optimal asset allocations vary considerably across these states and change over time as investors revise their estimates of the state probabilities. In the crash state, buy-and-hold investors allocate more of their portfolio to stocks the longer their investment horizon, while the optimal allocation to stocks declines as a function of the investment horizon in bull markets. The joint effects of learning about state probabilities and predictability of asset returns from the dividend yield give rise to a non-monotonic relationship between the investment horizon and the demand for stocks. Out-of-sample forecasting experiments confirm the economic importance of accounting for the presence of regimes in asset returns.

Keywords: Regime switching, Portfolio choice, Predictability

JEL Classification: G11, C22, C53

Suggested Citation

Timmermann, Allan and Guidolin, Massimo, Asset Allocation Under Multivariate Regime Switching (January 12, 2008). Journal of Economic Dynamics and Control, Vol. 31, No. 11, pp. 3503-3544, 2007, Available at SSRN: https://ssrn.com/abstract=1083124

Allan Timmermann

UCSD ( email )

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858-534-0894 (Phone)

HOME PAGE: http://rady.ucsd.edu/people/faculty/timmermann/

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Massimo Guidolin (Contact Author)

Bocconi University, Dept. of Finance ( email )

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2nd floor
Milan, MI 20136
Italy

Bocconi University - CAREFIN - Centre for Applied Research in Finance

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Milan, 20136
Italy

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