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Should Portfolio Model Inputs Be Estimated Using One or Two Economic Regimes?

Author

Listed:
  • Emmanouil Platanakis

    (School of Management, University of Bath)

  • Athanasios Sakkas

    (Southampton Business School, University of Southampton)

  • Charles Sutcliffe

    (ICMA Centre, Henley Business School, University of Reading)

Abstract

Estimation errors in the inputs are the main problem when applying portfolio analysis. Markov regime switching models are used to reduce these errors, but they do not always improve out-of-sample portfolio performance. We investigate the levels of transaction costs and risk aversion below which the use of two regimes is superior to one regime for an investor with a CRRA utility function, allowing for skewed and kurtic returns. Our results suggest that, due to differences in risk and transactions costs, most retail investors should use one regime models, while investment banks should use two regime models.

Suggested Citation

  • Emmanouil Platanakis & Athanasios Sakkas & Charles Sutcliffe, 2017. "Should Portfolio Model Inputs Be Estimated Using One or Two Economic Regimes?," ICMA Centre Discussion Papers in Finance icma-dp2017-07, Henley Business School, University of Reading.
    • Handle: RePEc:rdg:icmadp:icma-dp2017-07
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    References listed on IDEAS

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    More about this item

    Keywords

    finance; portfolio theory; regime shifting; transaction costs; risk aversion; constant relative risk aversion;
    All these keywords.

    JEL classification:

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

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