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Dynamic Portfolio Selection by Augmenting the Asset Space

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  • Michael W. Brandt
  • Pedro Santa-Clara
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    Abstract

    We present a novel approach to dynamic portfolio selection that is no more difficult to implement than the static Markowitz model. The idea is to expand the asset space to include simple (mechanically) managed portfolios and compute the optimal static portfolio in this extended asset space. The intuition is that a static choice among managed portfolios is equivalent to a dynamic strategy. We consider managed portfolios of two types: "conditional" and "timing" portfolios. Conditional portfolios are constructed along the lines of Hansen and Richard (1987). For each variable that affects the distribution of returns and for each basis asset, we include a portfolio that invests in the basis asset an amount proportional to the level of the conditioning variable. Timing portfolios invest in each basis asset for a single period and therefore mimic strategies that buy and sell the asset through time. We apply our method to a problem of dynamic asset allocation across stocks, bonds, and cash using the predictive ability of four conditioning variables.

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    Bibliographic Info

    Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 10372.

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    Date of creation: Mar 2004
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    Publication status: published as Brandt, Michael W. and Pedro Santa-Clara. "Dynamic Portfolio Selection By Augmenting The Asset Space," Journal of Finance, 2006, v61(5,Oct), 2187-2217.
    Handle: RePEc:nbr:nberwo:10372

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    1. Mark Britten-Jones, 1999. "The Sampling Error in Estimates of Mean-Variance Efficient Portfolio Weights," Journal of Finance, American Finance Association, American Finance Association, vol. 54(2), pages 655-671, 04.
    2. John Y. Campbell, 1990. "A Variance Decomposition for Stock Returns," NBER Working Papers 3246, National Bureau of Economic Research, Inc.
    3. Hansen, Lars Peter & Richard, Scott F, 1987. "The Role of Conditioning Information in Deducing Testable," Econometrica, Econometric Society, Econometric Society, vol. 55(3), pages 587-613, May.
    4. Ravi Jagannathan & Tongshu Ma, 2003. "Risk Reduction in Large Portfolios: Why Imposing the Wrong Constraints Helps," Journal of Finance, American Finance Association, American Finance Association, vol. 58(4), pages 1651-1684, 08.
    5. John Y. Campbell & Luis M. Viceira, 1996. "Consumption and Portfolio Decisions When Expected Returns are Time Varying," NBER Working Papers 5857, National Bureau of Economic Research, Inc.
    6. Ait-Sahalia, Y. & Brandt, M.W., 2001. "Variable Selection for Portfolio Choice," Papers, Manitoba - Department of Economics 34, Manitoba - Department of Economics.
    7. Hodrick, Robert J, 1992. "Dividend Yields and Expected Stock Returns: Alternative Procedures for Inference and Measurement," Review of Financial Studies, Society for Financial Studies, Society for Financial Studies, vol. 5(3), pages 357-86.
    8. Luboš Pástor & Robert F. Stambaugh, 1999. "Comparing Asset Pricing Models: An Investment Perspective," CRSP working papers, Center for Research in Security Prices, Graduate School of Business, University of Chicago 497, Center for Research in Security Prices, Graduate School of Business, University of Chicago.
    9. Cox, John C. & Huang, Chi-fu, 1989. "Optimal consumption and portfolio policies when asset prices follow a diffusion process," Journal of Economic Theory, Elsevier, Elsevier, vol. 49(1), pages 33-83, October.
    10. Brennan, Michael J. & Schwartz, Eduardo S. & Lagnado, Ronald, 1997. "Strategic asset allocation," Journal of Economic Dynamics and Control, Elsevier, Elsevier, vol. 21(8-9), pages 1377-1403, June.
    11. Keim, Donald B. & Stambaugh, Robert F., 1986. "Predicting returns in the stock and bond markets," Journal of Financial Economics, Elsevier, Elsevier, vol. 17(2), pages 357-390, December.
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    Cited by:
    1. Bansal, Ravi & Dahlquist, Magnus & Harvey, Campbell R., 2004. "Dynamic Trading Strategies and Portfolio Choice," SIFR Research Report Series, Institute for Financial Research 31, Institute for Financial Research.
    2. Brandt, Michael W & Santa-Clara, Pedro & Valkanov, Rossen, 2005. "Parametric Portfolio Policies: Exploiting Characteristics in the Cross Section of Equity Returns," University of California at Los Angeles, Anderson Graduate School of Management, Anderson Graduate School of Management, UCLA qt4ft420b6, Anderson Graduate School of Management, UCLA.
    3. Michael W. Brandt & Pedro Santa-Clara & Rossen Valkanov, 2009. "Parametric Portfolio Policies: Exploiting Characteristics in the Cross-Section of Equity Returns," Review of Financial Studies, Society for Financial Studies, Society for Financial Studies, vol. 22(9), pages 3411-3447, September.
    4. Martin D. D. Evans (Georgetown University) and Viktoria Hnatkovska (Georgetown University), 2005. "Solving General Equilibrium Models with Incomplete Markets and Many Assets," Working Papers, Georgetown University, Department of Economics gueconwpa~05-05-18, Georgetown University, Department of Economics.
    5. Bhaduri, Saumitra & Saraogi, Ravi, 2010. "The predictive power of the yield spread in timing the stock market," Emerging Markets Review, Elsevier, Elsevier, vol. 11(3), pages 261-272, September.

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