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

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  • Larsen, Linda Sandris
  • Munk, Claus

Abstract

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.

Suggested Citation

  • Larsen, Linda Sandris & Munk, Claus, 2012. "The costs of suboptimal dynamic asset allocation: General results and applications to interest rate risk, stock volatility risk, and growth/value tilts," Journal of Economic Dynamics and Control, Elsevier, vol. 36(2), pages 266-293.
    • Handle: RePEc:eee:dyncon:v:36:y:2012:i:2:p:266-293
    DOI: 10.1016/j.jedc.2011.09.009
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    Keywords

    Suboptimal investments; Wealth-equivalent utility loss; Stochastic interest rates; Stochastic volatility; Growth and value stocks; Mean reversion in stock returns;
    All these keywords.

    JEL classification:

    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions

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