Learning about predictability: The effects of parameter uncertainty on dynamic asset allocation

This paper examines the effects of uncertainty about the stock return predi ctability on optimal dynamic portfolio choice in a continuous time setting for a long-horizon investor. Uncertainty about the predictive relation affe cts the optimal portfolio choice through dynamic learning, and leads to a s tate-dependent relation between the optimal portfolio choice and the invest ment horizon. There is substantial market timing in the optimal hedge deman ds, which is caused by stochastic covariance between stock return and dynam ic learning. The opportunity cost of ignoring predictability or learning is found to be quite substantial.