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Optimal asset allocation with multivariate Bayesian dynamic linear models. (English) Zbl 1439.62245
Summary: We introduce a fast, closed-form, simulation-free method to model and forecast multiple asset returns and employ it to investigate the optimal ensemble of features to include when jointly predicting monthly stock and bond excess returns. Our approach builds on the Bayesian dynamic linear models of M. West and J. Harrison [Bayesian forecasting and dynamic models. 2nd ed. New York, NY: Springer (1997; Zbl 0871.62026)], and it can objectively determine, through a fully automated procedure, both the optimal set of regressors to include in the predictive system and the degree to which the model coefficients, volatilities and covariances should vary over time. When applied to a portfolio of five stock and bond returns, we find that our method leads to large forecast gains, both in statistical and economic terms. In particular, we find that relative to a standard no-predictability benchmark, the optimal combination of predictors, stochastic volatility and time-varying covariances increases the annualized certainty equivalent returns of a leverage-constrained power utility investor by more than 500 basis points.
MSC:
62P20 Applications of statistics to economics
62H12 Estimation in multivariate analysis
62M20 Inference from stochastic processes and prediction
Software:
bvarsv; rSGDLM
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