Upcoming Conferences
“Predictability of Stock Returns and Asset Allocation under Structural Breaks”
Allan Timmermann, UCSD
http://www.econ.ucsd.edu/~atimmerm/
Abstract:
An extensive literature in finance has found that return predictability can have important effects on optimal asset allocations. While some papers have also considered the portfolio effects of parameter and model uncertainty, model instability ('breaks') has received far less attention. This poses an important concern when the parameters of return prediction models are estimated on data samples spanning several decades during which the parameters are unlikely to remain stable. In this paper we adopt a new approach that accounts for breaks to return prediction models both in the historical estimation period and at future (out-of-sample) points. The analysis covers optimal asset allocation under parameter uncertainty, model uncertainty and uncertainty about the stability of the return forecasting model, as captured by the number of potential breaks. Our empirical findings suggest that model instability has a large e¤ect on the asset allocation when compared to the e¤ect of parameter estimation and model uncertainty. Thepossibility of future breaks has its largest e¤ect at long investment horizons, but historical (in-sample) breaks can significantly change investment decisions even at short horizons through its effect on current parameter estimates.
