Variable selection for portfolio choice

We study asset allocation when the conditional moments of returns are partl y predictable. Rather than first model the return distribution and subseque ntly characterize the portfolio choice, we determine directly the dependenc e of the optimal portfolio weights on the predictive variables. We combine the predictors into a single index that best captures time variations in in vestment opportunities. This index helps investors determine which economic variables they should track and, more importantly, in what combination. We consider investors with both expected utility (mean variance and CRRA) and nonexpected utility (ambiguity aversion and prospect theory) objectives an d characterize their market timing, horizon effects, and hedging demands.