Is Regime Switching in Stock Returns Important in Portfolio Decisions?

Working Paper, Singapore Management University

46 Pages Posted: 8 Nov 2007 Last revised: 15 Nov 2013

See all articles by Jun Tu

Jun Tu

Singapore Management University - Lee Kong Chian School of Business

Date Written: February 26, 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

JEL Classification: G11, G12, C11

Suggested Citation

Tu, Jun, Is Regime Switching in Stock Returns Important in Portfolio Decisions? (February 26, 2010). Working Paper, Singapore Management University, Available at SSRN: https://ssrn.com/abstract=1028445 or http://dx.doi.org/10.2139/ssrn.1028445

Jun Tu (Contact Author)

Singapore Management University - Lee Kong Chian School of Business ( email )

50 Stamford Road
#04-01
Singapore, 178899
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