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Optimal portfolio choice under regime switching, skew and kurtosis preferences

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  • Massimo Guidolin
  • Allan Timmerman

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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Bibliographic Info

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

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Keywords: Assets (Accounting);

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Citations

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Cited by:
  1. Eric Jondeau & Michael Rockinger, 2006. "Optimal Portfolio Allocation under Higher Moments," European Financial Management, European Financial Management Association, vol. 12(1), pages 29-55.
  2. Andrew Ang & Joseph Chen & Yuhang Xing, 2006. "Downside Risk," Review of Financial Studies, Society for Financial Studies, vol. 19(4), pages 1191-1239.
    • Andrew Ang & Joseph Chen & Yuhang Xing, 2005. "Downside risk," Proceedings, Board of Governors of the Federal Reserve System (U.S.).
  3. Meenagh, David & Minford, Patrick & Peel, David, 2007. "Simulating stock returns under switching regimes - A new test of market efficiency," Economics Letters, Elsevier, vol. 94(2), pages 235-239, February.
  4. Andrew Ang & Geert Bekaert, 2003. "How do Regimes Affect Asset Allocation?," NBER Working Papers 10080, National Bureau of Economic Research, Inc.
  5. Marie Briere & Alexandre Burgues & Ombretta Signori, 2008. "Volatility Exposure for Strategic Asset Allocation," Working Papers CEB 08-034.RS, ULB -- Universite Libre de Bruxelles.
  6. Taboga, Marco, 2005. "Portfolio selection with two-stage preferences," Finance Research Letters, Elsevier, vol. 2(3), pages 152-164, September.
  7. Zhengjun Jiang & Martijn Pistorius, 2008. "Optimal dividend distribution under Markov-regime switching," Papers 0812.4978, arXiv.org, revised Apr 2011.

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