We study a dynamic asset allocation problem in which expected stock returns are predictable, focusing on an investor with a medium-term horizon of up to five years. At these horizons, both return continuation (momentum) and mean-reversion are of central importance in the asset allocation problem. Researchers have extensively investigated the impact of mean-reversion on optimal portfolio choice, but its interplay with return continuation has not been explicitly addressed so far. We introduce a tractable continuous time model that captures these two predictability features of stock market returns. Our model predicts that hedging demands are negative for short to medium-term investors, and that the total allocation to stocks does not increase monotonically with the investor’s horizon. Moreover, the value of hedging time-variation in investment opportunities, i.e. acting strategically, is substantially higher in the presence of return continuation. The utility gains from including momentum are preserved if we impose realistic borrowing and short-sales constraints and allow the investor trade on a monthly frequency, but disappear at an annual trading frequency.

Momentum and Mean Reversion in Strategic Asset Allocation

SBUELZ, Alessandro
2006-01-01

Abstract

We study a dynamic asset allocation problem in which expected stock returns are predictable, focusing on an investor with a medium-term horizon of up to five years. At these horizons, both return continuation (momentum) and mean-reversion are of central importance in the asset allocation problem. Researchers have extensively investigated the impact of mean-reversion on optimal portfolio choice, but its interplay with return continuation has not been explicitly addressed so far. We introduce a tractable continuous time model that captures these two predictability features of stock market returns. Our model predicts that hedging demands are negative for short to medium-term investors, and that the total allocation to stocks does not increase monotonically with the investor’s horizon. Moreover, the value of hedging time-variation in investment opportunities, i.e. acting strategically, is substantially higher in the presence of return continuation. The utility gains from including momentum are preserved if we impose realistic borrowing and short-sales constraints and allow the investor trade on a monthly frequency, but disappear at an annual trading frequency.
2006
Dynamic asset allocation problem; predictability of stock returns.
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Utilizza questo identificativo per citare o creare un link a questo documento: https://hdl.handle.net/11562/31022
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