Post by Sapphire Capital on Mar 12, 2009 22:24:53 GMT 4
The Costs of Suboptimal Dynamic Asset Allocation: General Results and Applications to Interest Rate Risk, Stock Volatility Risk, and Growth/Value Tilts
Claus Munk
Aarhus University
Linda Sandris Larsen
University of Southern Denmark
February 5, 2009
Abstract:
The recent theoretical asset allocation literature has derived optimal dynamic investment strategies in a number of relatively advanced models of asset returns. But how important is it to get the intertemporal hedge absolutely correct or include the hedge term at all? Will unsophisticated investors do almost as well as sophisticated investors? More generally, how costly is it to deviate from the optimal investment strategy in some specific way? This paper develops a general approach to answering such questions and applies it to three specific models. First, in a setting with Vasicek interest rates, we demonstrate that the primary motive for including bonds in the portfolio is to improve the risk-return tradeoff, while the interest rate hedging motive is secondary. Second, in a model of stochastic stock market volatility, we show that the primary motive for investing in stock options is to improve the risk-return tradeoff, while volatility hedging is less important. The loss from excluding stock options is substantial. Third, we discuss the benefits from investing in growth stocks and value stocks in a model with mean reversion in the returns of those stocks, estimated on U.S. data. We find that growth/value tilts of the stock portfolio are highly valuable to investors, but that the intertemporal hedging of time-varying risk premia on stock portfolios are of minor importance.
papers.ssrn.com/sol3/Delivery.cfm/SSRN_ID1338074_code410452.pdf?abstractid=1338074&mirid=3
Claus Munk
Aarhus University
Linda Sandris Larsen
University of Southern Denmark
February 5, 2009
Abstract:
The recent theoretical asset allocation literature has derived optimal dynamic investment strategies in a number of relatively advanced models of asset returns. But how important is it to get the intertemporal hedge absolutely correct or include the hedge term at all? Will unsophisticated investors do almost as well as sophisticated investors? More generally, how costly is it to deviate from the optimal investment strategy in some specific way? This paper develops a general approach to answering such questions and applies it to three specific models. First, in a setting with Vasicek interest rates, we demonstrate that the primary motive for including bonds in the portfolio is to improve the risk-return tradeoff, while the interest rate hedging motive is secondary. Second, in a model of stochastic stock market volatility, we show that the primary motive for investing in stock options is to improve the risk-return tradeoff, while volatility hedging is less important. The loss from excluding stock options is substantial. Third, we discuss the benefits from investing in growth stocks and value stocks in a model with mean reversion in the returns of those stocks, estimated on U.S. data. We find that growth/value tilts of the stock portfolio are highly valuable to investors, but that the intertemporal hedging of time-varying risk premia on stock portfolios are of minor importance.
papers.ssrn.com/sol3/Delivery.cfm/SSRN_ID1338074_code410452.pdf?abstractid=1338074&mirid=3