Dynamic Portfolio Selection by Augmenting the Asset Space

Authors

  • MICHAEL W. BRANDT,

  • PEDRO SANTA-CLARA

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    • Brandt is at the Fuqua School of Business, Duke University, and is also affiliated with the NBER; Santa-Clara is at the Anderson School of Management, University of California Los Angeles, and is also affiliated with the NBER. We thank Michael Brennan, John Campbell, Rob Engle, Rick Green, Francis Longstaff, Eduardo Schwartz, Rob Stambaugh, Rossen Valkanov, Luis Viceira, Shu Yan, an anonymous referee, and seminar participants at the 2005 American Finance Association meetings, ABP Investments, Baruch College, Barclays Global Investors, European Central Bank, Lehman Brothers, New York University, and Morgan Stanley for helpful comments.

ABSTRACT

We present a novel approach to dynamic portfolio selection that is as easy to implement as the static Markowitz paradigm. We expand the set of assets to include mechanically managed portfolios and optimize statically in this extended asset space. We consider “conditional” portfolios, which invest in each asset an amount proportional to conditioning variables, and “timing” portfolios, which invest in each asset for a single period and in the risk-free asset for all other periods. The static choice of these managed portfolios represents a dynamic strategy that closely approximates the optimal dynamic strategy for horizons up to 5 years.

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