Sequential Optimal Portfolio Performance: Market and Volatility Timing

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 estimation risk, which is the substantial uncertainty present in estimating and forecasting expected returns.