The costs of suboptimal dynamic asset allocation: General results and applications to interest rate risk, stock volatility risk, and growth/value tilts

The recent theoretical asset allocation literature has derived optimal dynamic investment strategies in various advanced models of asset returns. But how sensitive is investor welfare to deviations from the theoretically optimal strategy? Will unsophisticated investors do almost as well as sophistic...

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Bibliographic Details
Published in:Journal of economic dynamics & control 2012-02, Vol.36 (2), p.266-293
Main Authors: Larsen, Linda Sandris, Munk, Claus
Format: Article
Language:English
Subjects:
Asset allocation
Economic control
Economic dynamics
Economic models
Financial risks
Growth and value stocks
Hedging
Interest rate risk
Interest rates
Investment policy
Mean reversion in stock returns
Stochastic interest rates
Stochastic volatility
Studies
Suboptimal investments
Volatility
Wealth-equivalent utility loss
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Summary:The recent theoretical asset allocation literature has derived optimal dynamic investment strategies in various advanced models of asset returns. But how sensitive is investor welfare to deviations from the theoretically optimal strategy? Will unsophisticated investors do almost as well as sophisticated investors? This paper develops a general theoretical framework for answering such questions and applies it to three specific models of interest rate risk, stochastic stock volatility, and mean reversion and growth/value tilts of stock portfolios. Among other things, we find that growth/value tilts are highly valuable, but the hedging of time-varying stock risk premia is less important.
ISSN:0165-1889
1879-1743
DOI:10.1016/j.jedc.2011.09.009