Professional Documents
Culture Documents
TODAY
Assumptions
Wealth is 1$, to abstract from wealth effects
Ascertains investor has constant relative risk
aversion (CRRA): dollar investment in risky asset
increases in wealth, but the share of wealth
invested in risky asset remains constant
No practical constraints: positivity or no short-sales
(x 0), no leverage (0 x 1)
SOLUTION
!"
#$
=
= 0.50
3 (20%)
Traditional portfolio advice: put 50% of wealth in
stocks
Note, Sharpe ratio of optimal portfolio is independent of %:
( )
.=
=
2%+0.5*
6%=5%
%=3
=2%
Slope=0.3
% = 1.5
0.5*20%=
10%
= 20%
2.
1.
Suppose T=5
Final wealth is the product of current wealth and uncertain oneperiod returns: 7> = 1 + , (1 + ,> )
9@
A
=
%
A
Conditional moments, as state of economy at t+4 unknown
Indirect utility: the maximum utility obtained at t+4,
10
max (;(7> ))
9C, 9@
11
GRAPHICAL REPRESENTATION
12
LESSONS
Dynamic portfolio choice over long horizons is
first and foremost about solving one-period
portfolio choice problems!
This view destroys two widely held
misconceptions:
2.
1.
13
14
15
!"
#$
16
For the two asset case (stock market and risk-free asset),
rebalancing is countercyclical:
Buy (sell) stocks after low (high) returns
Portfolio rebalancing ensures wealth remains to be
allocated optimally (in line with risk preferences) over
time, and is also advantageous if returns are
mean-reverting / predictable: prices drop when
expected future returns increase (more on
predictability later)
Example: Great depression
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With rebalancing: sell some stocks before they are hit hard in 1930,
and buy some stocks before they rebound in 1932
Reduces variance
and increases returns
Similar evidence obtains in recent financial crisis!
18
19
20
! ",
#$
I "
!
,
#$
21
22
THE CV-APPROACH
CV set out to find the optimal portfolio choice for buy-andhold investors with investment horizon K
(L)
(L)
(L)
+ ( 1)
M L
% ( M L )
%
(
)
M L
L
/OP ( , , ) is
where
the average per period
covariance of risky assets return with risk-free return
over horizon K
1.
Myopic demand of a K-period investor (as before)
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2.
25
26
27
28
! ",
#$
( 1)
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2.
3.
1.
30
2.
3.
1.
31
CONCLUSIONS
Rebalancing is the foundation of any long-term
investment strategy!
Under i.i.d. returns the optimal policy is to
rebalance to constant weights for both short- and
long-term investors.
When returns are predictable, the optimal shortrun portfolio changes over time, and the long-run
investor has additional opportunistic strategies
Liabilities need to be adequately matched before
the investment portfolio is constructed.
32
LITERATURE
Books
Ang, Asset Management, Ch. 2-4
Campbell and Viceira, Strategic Asset Allocation, Ch. 2-3
Articles
Erb and Harvey, 2006, The Tactical and Strategic Value of
Commodity Futures, Financial Analysts Journal.
Merton, 1973, An Intertemporal Capital Asset Pricing Model,
Econometrica
Campbell and Viceira, 2005, The term structure of the risk-return
trade-off, NBER Working Paper
Campbell and Viceira, 2005, The term structure of the risk-return
trade-off, Financial Analysts Journal
Goyal and Welch, 2008, A Comprehensive Look at The Empirical
Performance of Equity Premium Prediction, Review of Financial
Studies
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