State-dependent asset allocation using neural networks

Bradrania, Reza and Pirayesh Neghab, Davood (2021): State-dependent asset allocation using neural networks. Published in: European Journal of Finance , Vol. 28, No. 11 (12 August 2021): pp. 1130-1156.

Abstract

Changes in market conditions present challenges for investors as they cause performance to deviate from the ranges predicted by long-term averages of means and covariances. The aim of conditional asset allocation strategies is to overcome this issue by adjusting portfolio allocations to hedge changes in the investment opportunity set. This paper proposes a new approach to conditional asset allocation that is based on machine learning; it analyzes historical market states and asset returns and identifies the optimal portfolio choice in a new period when new observations become available. In this approach, we directly relate state variables to portfolio weights, rather than firstly modeling the return distribution and subsequently estimating the portfolio choice. The method captures nonlinearity among the state (predicting) variables and portfolio weights without assuming any particular distribution of returns and other data, without fitting a model with a fixed number of predicting variables to data and without estimating any parameters. The empirical results for a portfolio of stock and bond indices show the proposed approach generates a more efficient outcome compared to traditional methods and is robust in using different objective functions across different sample periods.

• Item Type: MPRA Paper
• Language: English
• Keywords: asset allocation; portfolio optimization; market state, machine learning; neural networks; performance ratio
• Subjects: C - Mathematical and Quantitative Methods > C1 - Econometric and Statistical Methods and Methodology: General; C - Mathematical and Quantitative Methods > C1 - Econometric and Statistical Methods and Methodology: General > C10 - General; C - Mathematical and Quantitative Methods > C1 - Econometric and Statistical Methods and Methodology: General > C15 - Statistical Simulation Methods: General; C - Mathematical and Quantitative Methods > C1 - Econometric and Statistical Methods and Methodology: General > C18 - Methodological Issues: General; C - Mathematical and Quantitative Methods > C5 - Econometric Modeling > C53 - Forecasting and Prediction Methods ; Simulation Methods; C - Mathematical and Quantitative Methods > C5 - Econometric Modeling > C55 - Large Data Sets: Modeling and Analysis; C - Mathematical and Quantitative Methods > C5 - Econometric Modeling > C58 - Financial Econometrics; G - Financial Economics > G0 - General; G - Financial Economics > G1 - General Financial Markets; G - Financial Economics > G1 - General Financial Markets > G11 - Portfolio Choice ; Investment Decisions; G - Financial Economics > G1 - General Financial Markets > G12 - Asset Pricing ; Trading Volume ; Bond Interest Rates; G - Financial Economics > G1 - General Financial Markets > G17 - Financial Forecasting and Simulation

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