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Optimal Asset Allocation with Multivariate Bayesian Dynamic Linear Models

Author

Listed:
  • Carlos Carvalho

    () (University of Texas at Austin)

  • Jared D. Fisher

    () (University of Texas at Austin)

  • Davide Pettenuzzo

    () (Brandeis University, Department of Economics)

Abstract

We introduce a simulation-free method to model and forecast multiple asset returns and employ it to investigate the optimal ensemble of features to include when jointly predicting monthly stock and bond excess returns. Our approach builds on the Bayesian Dynamic Linear Models of West and Harrison (1997), and it can objectively determine, through a fully automated procedure, both the optimal set of regressors to include in the predictive system and the degree to which the model coefficients, volatilities, and covariances should vary over time. When applied to a portfolio of five stock and bond returns, we find that our method leads to large forecast gains, both in statistical and economic terms. In particular, we find that relative to a standard no-predictability benchmark, the optimal combination of predictors, stochastic volatility, and time-varying covariances increases the annualized certainty equivalent returns of a leverage-constrained power utility investor by more than 500 basis points.

Suggested Citation

  • Carlos Carvalho & Jared D. Fisher & Davide Pettenuzzo, 2018. "Optimal Asset Allocation with Multivariate Bayesian Dynamic Linear Models," Working Papers 123, Brandeis University, Department of Economics and International Businesss School.
  • Handle: RePEc:brd:wpaper:123
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    File URL: http://www.brandeis.edu/economics/RePEc/brd/doc/Brandeis_WP123.pdf
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    References listed on IDEAS

    as
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    More about this item

    Keywords

    Optimal asset allocation; Bayesian econometrics; Dynamic Linear models;

    JEL classification:

    • C11 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Bayesian Analysis: General
    • C22 - Mathematical and Quantitative Methods - - Single Equation Models; Single Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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