Working Paper: NBER ID: w24222
Authors: Pierre Collin-Dufresne; Kent D. Daniel; Mehmet Sa Lam
Abstract: We solve a portfolio choice problem when expected returns, volatilities and trading-costs follow a regime-switching model. The optimal policy trades towards an aim portfolio given by a weighted-average of the conditional mean-variance portfolios in all future states. The trading speed is higher in more persistent, riskier and higher-liquidity states. It can be optimal to overweight low Sharpe-ratio assets such as Treasury bonds because they remain liquid even in crisis states. We illustrate our methodology by constructing an optimal US equity market timing portfolio based on an estimated regime-switching model and on trading costs estimated using a large-order institutional trading dataset.
Keywords: Dynamic Asset Allocation; Liquidity Regimes; Markov Switching Model
JEL Codes: D53; G11; G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| state of the market (G10) | asset allocation strategy (G11) |
| market conditions (P42) | trading behavior (G41) |
| transaction costs (D23) | asset allocation decisions (G11) |
| low Sharpe-ratio assets during crisis states (G19) | overweighting in asset allocation (G11) |
| dynamic trading strategy (C69) | performance compared to alternative strategies (G11) |