Predictable Returns and Asset Allocation: Should a Skeptical Investor Time the Market?

We investigate optimal portfolio choice for an investor who is skeptical about the degree to which excess returns are predictable. Skepticism is modeled as an informative prior over the R2 of the predictive regression. We find that the evidence is sufficient to convince even an investor with a highly skeptical prior to vary his portfolio on the basis of the dividend-price ratio and the yield spread. The resulting weights are less volatile and deliver superior out-of-sample performance as compared to the weights implied by an entirely model-based or data-based view.