Optimal portfolio strategies in the presence of regimes in asset returns

Carlos Heitor Campani, René Garcia and Marcelo Lewin

Journal of Banking & Finance, 2021, vol. 123, issue C

Abstract: This paper analyzes optimal portfolio and consumption strategies in a regime-switching economy with unobservable states and predictability of risky asset returns. We 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. We 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.

Keywords: Dynamic asset allocation; Stochastic differential utility; Consumption and portfolio optimal strategies; Regime switching economy; Predictability; Large and small caps; Size effects (search for similar items in EconPapers)
JEL-codes: C02 G11 (search for similar items in EconPapers)
Date: 2021
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (5)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:jbfina:v:123:y:2021:i:c:s0378426620302910

DOI: 10.1016/j.jbankfin.2020.106030

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