Publication Type

Journal Article

Version

Publisher’s Version

Publication Date

2010

Abstract

The stock market displays regime switching between upturns and downturns. This paper provides a Bayesian framework for making portfolio decisions that takes this regime switching into account, together with asset pricing model uncertainty and parameter uncertainty. The findings reveal that the economic value of accounting for regimes is substantially independent of whether or not model and parameter uncertainties are incorporated: the certainty-equivalent losses associated with ignoring regime switching are generally above 2% per year, and can be as high as 10%. These results suggest that the more realistic regime switching model is fundamentally different from the commonly used single-state model, and hence should be employed instead in portfolio decisions irrespective of concerns about model or parameter uncertainty.

Keywords

investments, model uncertainty, parameter uncertainty, regime switching, Bayesian analysis

Discipline

Finance and Financial Management | Portfolio and Security Analysis

Research Areas

Finance

Publication

Management Science

Volume

56

Issue

7

First Page

1198

Last Page

1215

ISSN

0025-1747

Identifier

10.1287/mnsc.1100.1181

Publisher

INFORMS

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