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Dynamic Investment Strategies Through Market Classification and Volatility: A Machine Learning Approach

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  • Jinhui Li
  • Wenjia Xie
  • Luis Seco

Abstract

This study introduces a dynamic investment framework to enhance portfolio management in volatile markets, offering clear advantages over traditional static strategies. Evaluates four conventional approaches : equal weighted, minimum variance, maximum diversification, and equal risk contribution under dynamic conditions. Using K means clustering, the market is segmented into ten volatility-based states, with transitions forecasted by a Bayesian Markov switching model employing Dirichlet priors and Gibbs sampling. This enables real-time asset allocation adjustments. Tested across two asset sets, the dynamic portfolio consistently achieves significantly higher risk-adjusted returns and substantially higher total returns, outperforming most static methods. By integrating classical optimization with machine learning and Bayesian techniques, this research provides a robust strategy for optimizing investment outcomes in unpredictable market environments.

Suggested Citation

  • Jinhui Li & Wenjia Xie & Luis Seco, 2025. "Dynamic Investment Strategies Through Market Classification and Volatility: A Machine Learning Approach," Papers 2504.02841, arXiv.org.
  • Handle: RePEc:arx:papers:2504.02841
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    References listed on IDEAS

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    1. Victor DeMiguel & Lorenzo Garlappi & Raman Uppal, 2009. "Optimal Versus Naive Diversification: How Inefficient is the 1-N Portfolio Strategy?," The Review of Financial Studies, Society for Financial Studies, vol. 22(5), pages 1915-1953, May.
    2. repec:dau:papers:123456789/4688 is not listed on IDEAS
    3. Mark Kritzman & Sébastien Page & David Turkington, 2010. "In Defense of Optimization: The Fallacy of 1/N," Financial Analysts Journal, Taylor & Francis Journals, vol. 66(2), pages 31-39, March.
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