Asset Allocation under Multivariate Regime Switching

This paper studies asset allocation decisions in the presence of regime switching in asset returns. Wefind evidence that four separate regimes - characterized as crash, slow growth, bull and recovery states- are required to capture the joint distribution of stock and bond returns. Optimal asset allocationsvary considerably across these states and change over time as investors revise their estimates of thestate probabilities. In the crash state, buy-and-hold investors allocate more of their portfolio to stocksthe longer their investment horizon, while the optimal allocation to stocks declines as a function ofthe investment horizon in bull markets. The joint effects of learning about state probabilities andpredictability of asset returns from the dividend yield give rise to a non-monotonic relationship betweenthe investment horizon and the demand for stocks....