Predictability-Robust Dynamic Portfolio Choice

Abstract

Dynamic portfolio choice crucially depends on the predictability of returns. In contrast to its importance, confirmation of the existence of predictability is lacking. We consider a robust investor who arms herself against the adverse effects of uncertainty about predictability but also exploits the benefits of predictability insofar it is significant. We show that robust dynamic portfolio choice does not exhibit the extreme risky investment of traditional and Bayesian portfolios, is less volatile and features intertemporal hedging demands. We also show the worst plausible form of predictability for the robust portfolio result. This worst case depends on the horizon, initial state, the portfolio, and the relations among the predictor variables. For long term investment the worst case features a low long term average of the predictor variable and a high exposure to this low average.