This paper presents evidence of persistent `bull' and `bear' regimes in UK stock returns and considers their economic implications from the perspective of an investor's portfolio decisions. We find that the perceived state probability has a large effect on the optimal allocation to stocks, particularly at short investment horizons. If ignored, the presence of such regimes gives rise to welfare costs that are substantial, particularly in the bear state where stock holdings should be significantly reduced. When we extend the return forecasting model to allow for predictability from the lagged dividend yield, we find that both dividend yields and regime switching have strong effects on the optimal asset allocation.
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