STRATEGIC ASSET ALLOCATION

This paper analyzes the portfolio problem of an investor who can inves t in bonds, stock, and cash when there is time variation in expected r eturns on the asset classes. The time variation is assumed to be drive n by three state variables, the short-term interest rate, the rate on long-term bonds, and the dividend yield on a stock portfolio, which ar e all assumed to follow a joint Markov process. The process is estimat ed from empirical data and the investor's optimal control problem is s olved numerically for the resulting parameter values. The optimal port folio proportions of an investor with a long horizon are compared with those of an investor with a short horizon such as is typically assume d in tactical asset allocation' models: they are found to be significa ntly different. Out of sample simulation results provide encouraging e vidence that the predictability of asset returns is sufficient for str ategies that take it into account to yield significant improvements in portfolio returns.