Sequential Optimal Portfolio Performance: Market and Volatility Timing
Michael S. Johannes, Nicholas G. Polson, Jonathan R. Stroud
Columbia University, University of Chicago, and George Washington
This paper studies the economic benefits of return predictability by analyzing the impact
of market and volatility timing on the performance of optimal portfolio rules. Using a model
with time-varying expected returns and volatility, we form optimal portfolios sequentially
and generate out-of-sample portfolio returns. We are careful to account for estimation risk
and parameter learning. Using S&P 500 index data from 1980-2000, we find that a strategy
based solely on volatility timing uniformly outperforms market timing strategies, a model that
assumes no predictability and the market return in terms of certainty equivalent gains and Sharpe
ratios. Market timing strategies perform poorly due to estimation risk, which is the substantial
uncertainty present in estimating and forecasting expected returns.
The manuscript is available in PDF format.