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Optimal portfolio choice under regime switching, skew and kurtosis preferences

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Author Info
Massimo Guidolin
Allan Timmerman

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Abstract

This paper proposes a new tractable approach to solving multi-period asset allocation problems. We assume that investor preferences are defined over moments of the terminal wealth distribution such as its skew and kurtosis. Time-variations in investment opportunities are driven by a regime switching process that can capture bull and bear states. We develop analytical methods that only require solving a small set of difference equations and thus are very convenient to use. These methods are applied to a simple portfolio selection problem involving choosing between a stock index and a risk-free asset in the presence of bull and bear states in the return distribution. If the market is in a bear state, investors increase allocations to stocks the longer their time horizon. Conversely, in bull markets it is optimal for investors to decrease allocations to stocks the longer their investment horizon.

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Paper provided by Federal Reserve Bank of St. Louis in its series Working Papers with number 2005-006.

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Date of creation: 2005
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Handle: RePEc:fip:fedlwp:2005-006

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Keywords: Assets (Accounting);

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References listed on IDEAS
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Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Andrew Ang & Geert Bekaert, 2003. "How do Regimes Affect Asset Allocation?," NBER Working Papers 10080, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  2. Meenagh, David & Minford, Patrick & Peel, David, 2006. "Simulating Stock Returns under switching regimes - a new test of market efficiency," Cardiff Economics Working Papers E2006/13, Cardiff University, Cardiff Business School, Economics Section. [Downloadable!]
    Other versions:
  3. Marie Brière & Alexandre Burgues & Ombretta Signori, 2008. "Volatility Exposure for Strategic Asset Allocation," Working Papers CEB 08-034.RS, Université Libre de Bruxelles, Solvay Brussels School of Economics and Management, Centre Emile Bernheim (CEB). [Downloadable!]
  4. Markus Haas, 2007. "Do investors dislike kurtosis?," Economics Bulletin, Economics Bulletin, vol. 7(2), pages 1-9. [Downloadable!]
  5. Marco Taboga, 2005. "Portfolio Selection with Two-Stage Preferences," Finance 0506009, EconWPA. [Downloadable!]
    Other versions:
  6. Andrew Ang & Joseph Chen & Yuhang Xing, 2005. "Downside Risk," NBER Working Papers 11824, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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