Optimal Asset Allocation Over the Business Cycle

Abstract

Abstract Utilizing a broadly diversified portfolio of nine equity and debt assets, we show our portfolio's in‐sample Markowitz return/risk profile considerably improved by keying asset proportions to cyclical changes in economic activity. For comparative purposes, we use the same assets in a hypothetical buy‐and‐hold benchmark portfolio. We find the variance/covariance structure of our portfolio to be considerably altered by the phase of the business cycle, with the diversification benefits enjoyed during expansions substantially diluted during recessions. Thus, cyclical reallocation appears to be more important in maintaining Markowitz efficiency during recessions vis‐a‐vis expansions. In the latter case we find expansion reallocation producing a 3.53% increase in our portfolio's return‐to‐risk ratio (relative to a buy‐and‐hold position), while for recessions optimal reallocation leads to a 79.14% increase.

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