Strategic asset allocation

This paper analyzes the portfolio problem of an investor who can invest in bonds, stock, and cash when there is time variation in expected returns on the asset classes. The time variation is assumed to be driven by three state variables, the short-term interest rate, the rate on long-term bonds, and the dividend yield on a stock portfolio, which are all assumed to follow a joint Markov process. The process is estimated from empirical data and the investor's optimal control problem is solved numerically for the resulting parameter values. The optimal portfolio proportions of an investor with a long horizon are compared with those of an investor with a short horizon such as is typically assumed in tactical asset allocation' models: they are found to be significantly different. Out of sample simulation results provide encouraging evidence that the predictability of asset returns is sufficient for strategies that take it into account to yield significant improvements in portfolio returns.