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Large Drawdowns and Long-Term Asset Management

Eric Jondeau (eric.jondeau@unil.ch) and Alexandre Pauli
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Eric Jondeau: Faculty of Business and Economics (HEC Lausanne), Swiss Finance Institute and CEPR, University of Lausanne, CH 1015 Lausanne, Switzerland
Alexandre Pauli: Ecole Polytechnique Fédérale de Lausanne, Route Cantonale, CH 1015 Lausanne, Switzerland

JRFM, 2024, vol. 17, issue 12, 1-29

Abstract: Long-term investors are often hesitant to invest in assets or strategies prone to significant drawdowns, primarily due to the challenge of predicting these drawdowns. This study presents a multivariate Markov-switching model for small- and large-cap returns in the U.S. equity markets, demonstrating that three distinct regimes are necessary to capture the negative trends in expected returns during financial crises. Our findings indicate that this framework enhances the prediction of conditional drawdowns compared to standard alternative models of financial returns. Furthermore, out-of-sample analysis shows that investment strategies based on these predictions outperform those relying on models with one or two regimes.

Keywords: large drawdowns; stock-market returns; Markov-switching model; portfolio allocation model (search for similar items in EconPapers)
JEL-codes: C E F2 F3 G (search for similar items in EconPapers)
Date: 2024
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