Asset allocation: How much does model choice matter?

This paper analyzes the optimal portfolio decision of a CRRA investor in models with stochastic volatility and stochastic jumps. The investor follows a buy-and-hold strategy in the stock, the money market account, and one additional derivative. We show that both the type of the model and the structure of the risk premia have a significant impact on the optimal portfolio, on the utility gain from having access to derivatives, and on whether the investor prefers to trade OTM or ATM options. We also show that model mis-specification results in significant utility losses. Omitting jumps in volatility can be devastating, in particular if the investor chooses the seemingly optimal OTM put options. A misestimation of the structure of the risk premia has a less devastating effect, but can still lead to a loss of around 4% in the annual certainty equivalent return. (C) 2012 Elsevier B.V. All rights reserved.