Optimal Portfolio Choice under Regime Switching, Skew and Kurtosis Preferences

Abstract

This paper proposes a new tractable approach to solving multi-period asset allocation problems.We assume that investor preferences are deÞned over moments of the terminal wealth distribution such as its skew and kurtosis.Time-variations in investment opportunities are driven by a regime switching process that can capture bull and bear states.We develop analytical methods that only require solving a small set of difference equations and thus are very convenient to use.These methods are applied to a simple portfolio selection problem involving choosing between a stock index and a risk-free asset in the presence of bull and bear states in the return distribution.If the market is in a bear state, investors increase allocations to stocks the longer their time horizon.Conversely, in bull markets it is optimal for investors to decrease allocations to stocks the longer their investment horizon.

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