Market Timing and Risk Reduction

Abstract

This paper addresses both how best to incorporate forecasts of future excess market re? turns into a market-timing strategy and what additional return to expect as a consequence. In contrast to the work of Jensen [8] and Grant ([4], [5], and [6]), the results specifically consider and measure the attractiveness to a risk-averse investor of the positively skewed distribution of portfolio returns expected from a market-timed portfolio. The usual mean and variance characterization of a risky portfolio is not sufficient in the case of a markettimed portfolio, and a simple utility model is employed to measure the incremental value of a market-timing strategy. The results are given as a function ofthe relative volatility of the market, the quality of available forecasts, and the risk attitude ofthe investor.