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Working Paper 2005-006A

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"Optimal Portfolio Choice under Regime Switching, Skew and Kurtosis Preferences"
by Massimo Guidolin

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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Category > Applied Econometrics
Category > Finance
Author > Massimo Guidolin