Disasters, Large Drawdowns, and Long-term Asset Management

Eric Jondeau and Alexandre Pauli
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Alexandre Pauli: University of Lausanne and Swiss Finance Institute

No 21-37, Swiss Finance Institute Research Paper Series from Swiss Finance Institute

Abstract: Long-term investors are often reluctant to invest in assets or strategies that can suffer from large drawdowns. A major challenge for such investors is to gain access to predictions of large drawdowns in order to precisely design strategies minimizing these drawdowns. In this paper, we describe a multivariate Markov-switching model framework that allows us to predict large drawdowns. We provide evidence that three regimes are necessary to capture the negative trends in expected returns that generate large drawdowns, and we correctly predict conditional drawdowns. In addition, investment strategies based on these models outperform model-free strategies based on the empirical distribution of drawdowns. These results hold within and out of the sample.

Keywords: Large drawdowns; Stock-market returns; Markov-switching model; Portfolio allocation model (search for similar items in EconPapers)
JEL-codes: C53 G15 (search for similar items in EconPapers)
Pages: 50 pages
Date: 2021-06
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Persistent link: https://EconPapers.repec.org/RePEc:chf:rpseri:rp2137

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