Timing and Diversification: A State-Dependent Asset Allocation Approach

The influence of changing economic environment leads the distribution of stock market returns to be time-varying. This requires a dynamic adjustment of the asset allocation in order to enjoy a conditionally optimal investment. In this context, we examine the improvement of the portfolio performance by simulating portfolio strategies that are conditioned on the Markov regime switching behavior of stock market returns. Including a memory effect eliminates the empirical shortcoming of discrete state models that they produce a standard and an extreme state in stock returns. So far, this has prevented the regimes of being used as a valuable conditioning variable. Based on a discrete state indicator variable we present evidence of considerable performance improvement relative to the static model due to optimal shifting between aggressive and well diversified portfolio structures.