Optimal portfolio choice for unobservable and regime-switching mean returns

We study dynamic optimal consumption and portfolio choice for a setting in which the mean returns of a risky asset depend on an unobservable regime variable of the economy, which is defined as a continuous-time Markov chain. The investor estimates the current regime by observing past and present asset prices. We compute the optimal consumption and portfolio policies of an investor with power utility. The optimal consumption/portfolio rule of a long-time-horizon investor could be substantially different from that of a short-time-horizon investor. The difference is caused by an investor's hedging demand of assets against fluctuations in the estimated mean returns. (C) 2002 Elsevier Science B.V. All rights reserved.