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Is Regime Switching in Stock Returns Important in Portfolio Decisions?

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  • Jun Tu

    () (Lee Kong Chian School of Business, Singapore Management University, Singapore 178899)

Abstract

The stock market displays regime switching between upturns and downturns. This paper provides a Bayesian framework for making portfolio decisions that takes this regime switching into account, together with asset pricing model uncertainty and parameter uncertainty. The findings reveal that the economic value of accounting for regimes is substantially independent of whether or not model and parameter uncertainties are incorporated: the certainty-equivalent losses associated with ignoring regime switching are generally above 2% per year and can be as high as 10%. These results suggest that the more realistic regime switching model is fundamentally different from the commonly used single-state model, and hence should be employed instead in portfolio decisions irrespective of concerns about model or parameter uncertainty.

Suggested Citation

  • Jun Tu, 2010. "Is Regime Switching in Stock Returns Important in Portfolio Decisions?," Management Science, INFORMS, vol. 56(7), pages 1198-1215, July.
  • Handle: RePEc:inm:ormnsc:v:56:y:2010:i:7:p:1198-1215
    DOI: 10.1287/mnsc.1100.1181
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    File URL: http://dx.doi.org/10.1287/mnsc.1100.1181
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    References listed on IDEAS

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