Learning about Predictability: The Effects of Parameter Uncertainty on Dynamic Asset Allocation

Abstract

ABSTRACT This paper examines the effects of uncertainty about the stock return predictability on optimal dynamic portfolio choice in a continuous time setting for a longhorizon investor. Uncertainty about the predictive relation affects the optimal portfolio choice through dynamic learning, and leads to a state‐dependent relation between the optimal portfolio choice and the investment horizon. There is substantial market timing in the optimal hedge demands, which is caused by stochastic covariance between stock return and dynamic learning. The opportunity cost of ignoring predictability or learning is found to be quite substantial.