Return predictability and intertemporal asset allocation: Evidence from a bias-adjusted VAR model

Within a VAR based intertemporal asset allocation model we explore the effects on return predictability and optimal asset allocation of adjusting VAR parameter estimates for small-sample bias. We apply a simple and easy-to-use analytical bias formula instead of bootstrap or Monte Carlo bias-adjustment. Regarding return predictability we show that bias-adjustment in the multivariate setup can yield very different results than in the univariate case. Furthermore, bias-correcting the VAR parameters has both quantitatively and qualitatively important effects on the optimal portfolio choice. For intermediate values of risk-aversion, the intertemporal hedging demand for bonds and stocks is heavily affected by the bias-correction. Utility calculations also show large effects of bias-adjustment, both in-sample and out-of-sample.

► We bias-correct VAR parameters in a dynamic asset allocation model. ► Correcting for bias affects return predictability in the VAR system. ► Correcting for bias affects optimal asset allocation both quantitatively and qualitatively.