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Optimal Asset Allocation with Multivariate Bayesian Dynamic Linear Models

Carlos Carvalho (), Jared Fisher () and Davide Pettenuzzo ()
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Carlos Carvalho: University of Texas at Austin
Jared Fisher: University of Texas at Austin

No 123, Working Papers from Brandeis University, Department of Economics and International Businesss School

Abstract: We introduce a simulation-free method to model and forecast multiple asset returns and employ it to investigate the optimal ensemble of features to include when jointly predicting monthly stock and bond excess returns. Our approach builds on the Bayesian Dynamic Linear Models of West and Harrison (1997), and it can objectively determine, through a fully automated procedure, both the optimal set of regressors to include in the predictive system and the degree to which the model coefficients, volatilities, and covariances should vary over time. When applied to a portfolio of five stock and bond returns, we find that our method leads to large forecast gains, both in statistical and economic terms. In particular, we find that relative to a standard no-predictability benchmark, the optimal combination of predictors, stochastic volatility, and time-varying covariances increases the annualized certainty equivalent returns of a leverage-constrained power utility investor by more than 500 basis points.

Keywords: Optimal asset allocation; Bayesian econometrics; Dynamic Linear models (search for similar items in EconPapers)
JEL-codes: C11 C22 G11 G12 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-ecm, nep-for, nep-ore and nep-rmg
Date: 2018-09
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