Momentum and Mean Reversion in Strategic Asset Allocation

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. We would like to thank Theo Nijman, Anna Pavlova, Pieter Jelle van der Sluis, Jules van Binsbergen, and Bas Werker and seminar participants at the University of Salerno, University of Konstanz, VII Workshop on Quantitative Finance, University of Perugia, International Summer School in ’Risk Measurement and Control’, University of Rome ”La Sapienza” for useful discussions and suggestions. Department of Finance and CentER, Tilburg University, P.O. Box 90153, 5000 LE, Tilburg, The Netherlands. Phone: +31-13-466-3238, Fax: +31-13-466-2875, E-mail: [email protected]. Department of Finance and CentER, Tilburg University, P.O. Box 90153, 5000 LE, Tilburg, The Netherlands. Phone: +31-13-466-3262, Fax: +31-13-466-2875, E-mail: [email protected]. Economics Department, SAFE Center, University of Verona, Via Giardino Giusti 2, 37129, Verona, Italy, Phone: +39-045-8054922, Fax: +39-045-8054935, E-mail: [email protected].