Strategic Asset Allocation and Consumption Decisions under Multivariate Regime Switching

This paper studies optimal asset allocation to stocks, long-term bonds and T-bills and consumption choice in the presence of regime switching in asset returns. Optimal asset allocations vary considerably across four states - both across bonds and stocks and among large and small stocks - and change significantly over time as investors revise their estimates of the current state probabilities. In the crash state investors always allocate more of their portfolio to stocks the longer their investment horizon, while the optimal allocation to stocks declines as a function of the investment horizon in bull markets. Consumption-to-wealth ratios are also found to depend on the underlying state. Welfare costs from ignoring regime switching are substantial, especially when frequent rebalancing is considered. Results are found to be robust to changes in risk aversion, the imposition of short sale restrictions, the inclusion of standard predictor variables such as the dividend yield and to parameter uncertainty