Is Regime Switching in Stock Returns Important in Asset Allocations?

• Main Author: TU, Jun
• Format: text
• Language: English
• Published: Institutional Knowledge at Singapore Management University 2008
• Subjects: investments; asset pricing tests; data generating process; regime switching; Bayesian analysis; Finance and Financial Management; Portfolio and Security Analysis
• Online Access: https://ink.library.smu.edu.sg/lkcsb_research/1107
• Institution: Singapore Management University

The stock market undergoes regime switching between upturns and downturns. We provide a framework of making investment decisions that accounts for this regime switching together with asset pricing model uncertainty and parameter uncertainty. Once regime switching is incorporated, regardless of the degrees of pricing model uncertainties, we find that the portfolio decisions can deviate from those ignoring regime switching substantially. The resulting certainty-equivalent losses associated with ignoring regime switching are generally above 2% per year and can exceed 10% per year during market downturns. This suggests that regime switching is of important economic consequence and cannot be ignored in making investment decisions.