On the Exact Solution of the Multi-Period Portfolio Choice Problem for an Exponential Utility under Return Predictability

TL;DR

This paper derives an exact multi-period portfolio optimization solution considering return predictability and demonstrates its application through empirical wealth distribution analysis.

Contribution

It provides the first exact solution for multi-period portfolio choice with return predictability under exponential utility, extending previous models.

Findings

Optimal portfolio weights depend on future covariance and mean estimates.

The exact solution generalizes previous models without predictable variables.

Empirical analysis compares wealth distributions under different return assumptions.

Abstract

In this paper we derive the exact solution of the multi-period portfolio choice problem for an exponential utility function under return predictability. It is assumed that the asset returns depend on predictable variables and that the joint random process of the asset returns and the predictable variables follow a vector autoregressive process. We prove that the optimal portfolio weights depend on the covariance matrices of the next two periods and the conditional mean vector of the next period. The case without predictable variables and the case of independent asset returns are partial cases of our solution. Furthermore, we provide an empirical study where the cumulative empirical distribution function of the investor's wealth is calculated using the exact solution. It is compared with the investment strategy obtained under the additional assumption that the asset returns are independently distributed.