Strategic and tactical asset allocation and the effect of long-run equilibrium relations

This article focuses on the relevance of long-term equilibrium relations for financial decision making. Special attention is devoted to optimal asset allocation in the presence of possibly cointegrated time-series, e.g., asset prices. Using a stylized asset allocation problem, the link is established between the number of cointegrating relations and their precise form on the one hand, and the optimal asset allocation on the other hand. The paper disentangles the different effects of long-term relations on optimal asset allocation with different planning horizons: error-correction mainly affects tactical asset allocation, while cointegration affects strategic asset allocation. The paper also presents results on the effects of incorporating an incorrect number of error-correction mechanisms in financial decision models. Mis-specifying the number of cointegrating relations in a scenario generator can induce either inefficient or overly risky financial management decisions. The findings are illustrated using a stylized empirical example from currency management.