Research and publications

Optimal Portfolio Strategies in the Presence of Regimes in Asset Returns

This paper analyses optimal portfolio and consumption strategies in a regime-switching economy with unobservable states and predictability of risky asset returns. Authors develop approximate analyt ...

Author(s) :

Carlos Heitor Campania, René Garcia, Marcelo Lewina

Summary :

This paper analyses optimal portfolio and consumption strategies in a regime-switching economy with unobservable states and predictability of risky asset returns. Authors develop approximate analytical solutions to the unconstrained dynamic problem. The approximation is shown to be fast and accurate in a four-regime setting with an allocation to four assets compared to the numerical solution developed in Guidolin and Timmermann (2007). The computation time of the approximate solution is shown to be practically independent of the number of assets when no predictors are present and only marginally affected by the number of predictors. While the portfolio policy strongly depends on the current state of the economy, the consumption-to-wealth ratio is roughly state-independent. Predictability considerably changes the optimal portfolios. Hedging demands are negligible with regimes and no predictability, but are important with predictability. On the other hand, the consumption-to-wealth ratio is not very impacted by the predictor. They provide an out-of-sample statistical assessment of the returns provided by a multi-regime strategy with respect to a single-regime and to a 1/N strategy.

Type : Academic Publication
Date : 04/01/2021
Keywords :


Dynamic asset allocation
Stochastic differential utility
Consumption and portfolio optimal strategies
Regime switching economy
Predictability
Large and small caps
Size effects
 

Editor : Journal of Banking & Finance, Volume 123, February 2021, 106030