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Should Portfolio Model Inputs Be Estimated Using One or Two Economic Regimes?

Emmanouil Platanakis (), Athanasios Sakkas () and Charles Sutcliffe ()
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Emmanouil Platanakis: School of Management, University of Bath
Athanasios Sakkas: Southampton Business School, University of Southampton

No icma-dp2017-07, ICMA Centre Discussion Papers in Finance from Henley Business School, Reading University

Abstract: Estimation errors in the inputs are the main problem when applying portfolio analysis. Markov regime switching models are used to reduce these errors, but they do not always improve out-of-sample portfolio performance. We investigate the levels of transaction costs and risk aversion below which the use of two regimes is superior to one regime for an investor with a CRRA utility function, allowing for skewed and kurtic returns. Our results suggest that, due to differences in risk and transactions costs, most retail investors should use one regime models, while investment banks should use two regime models.

Keywords: finance; portfolio theory; regime shifting; transaction costs; risk aversion; constant relative risk aversion (search for similar items in EconPapers)
JEL-codes: G11 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-ore, nep-rmg and nep-upt
Date: 2017-09
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