Optimal Consumption and Investment with Transaction Costs and Multiple Risky Assets

We consider the optimal intertemporal consumption and investment policy of a constant absolute risk aversion (CARA) investor who faces fixed and proportional transaction costs when trading multiple risky assets. We show that when asset returns are uncorrelated, the optimal investment policy is to keep the dollar amount invested in each risky asset between two constant levels and upon reaching either of these thresholds, to trade to the corresponding optimal targets. An extensive analysis suggests that transaction cost is an important factor in affecting trading volume and that it can significantly diminish the importance of stock return predictability as reported in the literature.     

The Role of Learning in Dynamic Portfolio Decisions

This paper analyzes the effect of uncertainty about the mean return on the risky asset on the portfolio decisions of an investor who has a long investment horizon. Building on the earlier work of Detemple (1986), Dothan and Feldman (1986), and Gennotte (1986), it is shown that the possibility of future learning about the mean return on the risky asset induces the investor to take a larger or smaller position in the risky asset than she would if there were no learning, the direction of the effect depending on whether the investor is more or less risk tolerant than the logarithmic investor whose portfolio decisions are unaffected by the possibility of future learning. Numerical calculations show that uncertainty about the mean return on the market portfolio has a significant effect on the portfolio decision of an investor with a 20 year horizon if her assessment of the market risk premium is based solely on the Ibbotson and Sinquefield (1995) data.     

KNOW YOUR CLIENT! INVESTOR PROFILE AND TAILOR‐MADE ASSET ALLOCATION RECOMMENDATIONS

We study how the investor profile influences the asset allocation recommendations of professional advisors. We find the investor's perceived risk attitude influences more the mix of risky assets, whereas the socioeconomic variables influence more the cash percentage. The recommendations are consistent with a diversification behavior driven by actual asset correlations. These findings support the utility of investor advisory that may help enhance the risk and return trade‐off. The main drawback of the recommendations may consist in the degree of customization that is limited by the small number of investor characteristics actually influencing the asset allocation.     

The Role of Learning in Dynamic Portfolio Decisions

This paper analyzes the effect of uncertainty about the meanreturn on the risky asset on the portfolio decisions of an investorwho has a long investment horizon. Building on the earlier workof Detemple (1986), Dothan and Feldman (1986), and Gennotte(1986), it is shown that the possibility of future learningabout the mean return on the risky asset induces the investorto take a larger or smaller position in the risky asset thanshe would if there were no learning, the direction of the effectdepending on whether the investor is more or less risk tolerantthan the logarithmic investor whose portfolio decisions areunaffected by the possibility of future learning. Numericalcalculations show that uncertainty about the mean return onthe market portfolio has a significant effect on the portfoliodecision of an investor with a 20 year horizon if her assessmentof the market risk premium is based solely on the Ibbotson andSinquefield (1995) data.     

On the Optimality of Portfolio Insurance

This paper examines the optimality of an insurance strategy in which an investor buys a risky asset and a put on that asset. The put's striking price serves as the insurance level. In complete markets, it is highly unlikely that an investor would utilize such a strategy. However, in some types of less complete markets, an investor may wish to purchase a put on the risky asset. Given only a risky asset, a put, and noncontinuous trading, an investor would purchase a put as a way of introducing a risk-free asset into the portfolio. If, in addition, there is a risk-free asset and the investor's utility function displays constant proportional risk-aversion, then the investor would buy the risk-free asset directly and not buy a put. In sum, only under the most incomplete markets would an investor find an insurance strategy optimal.     

Portfolio rebalancing and the transmission of large-scale asset purchase programs: Evidence from the Euro area

The European Central Bank's large-scale asset purchase program targeted safe assets, but also aimed to impact prices of risky assets. The mechanism for this is the “portfolio rebalancing channel”, where financial institutions’ portfolio decisions impact financial prices more broadly. We examine this mechanism using cross-sectional heterogeneity in how the financial portfolios of different sectors of the European economy were affected around the purchase program. We find evidence of rebalancing. In vulnerable countries, where macroeconomic unbalances and relatively high risk premia remained, we document rebalancing towards riskier securities. In less vulnerable countries, based on granular information for large European banks, we document rebalancing toward bank loans.     

Robust consumption and portfolio choice for time varying investment opportunities

This paper examines a continuous-time intertemporal consumption and portfolio choice problem for an investor with recursive preferences. The investor worries about model misspecification and seeks robust decision rules. The expected excess return of a risky asset follows a mean-reverting process. I find that whether the concern about model misspecification decreases the total demand for equities largely depends on risk aversion and the attitude toward intertemporal substitution. When the elasticity of intertemporal substitution is about 1 and risk aversion is moderate, the aversion to model uncertainty increases the proportion of wealth invested in equities. The calibration analysis based on detection-error probabilities shows that the quantitative effect of robustness is almost negligible.     

Predictability and diversification benefits of investing in commodity and currency futures

We re-examine diversification benefits of investing in commodities and currencies by considering a risk-averse investor with mean-variance preferences who exploits the possibility of predictable time variation in asset return means, variances, and covariances. We implement unconditional and conditional efficient portfolio strategies designed to exploit this predictability, together with more traditional and/or ad hoc ones yet hitherto relatively unexplored in this context (including the equally weighted, fixed weight, volatility timing, and reward-to-risk timing strategies). We find that, for all portfolio strategies, commodities and currencies do not improve the investment opportunity set of the investor with an existing portfolio of stocks, bonds and T-bills, and an investment horizon of one month. Our findings, which reverse the conclusions of previous studies that focus on static portfolio strategies, are robust across several performance metrics.     

Risk-neutral investors do not acquire information

Give a risk-neutral investor the choice to acquire a costly signal prior to asset market equilibrium. She refuses to pay for the signal under general conditions. The reason is that a risk-neutral investor is indifferent between a risky asset or a safe bond in optimum and expects the same return to her portfolio ex ante, whether or not she acquires information. Risk neutrality thus implies the absence of costly information from asset price in competitive asset markets.     

Constant proportion portfolio insurance strategies in contagious markets

Constant Proportion Portfolio Insurance (CPPI) strategies are popular as they allow to gear up the upside potential of a stock index while limiting its downside risk. From the issuer’s perspective it is important to adequately assess the risks associated with the CPPI, both for correct ‘gap’ fee charging and for risk management. The literature on CPPI modelling typically assumes diffusive or Lévy-driven dynamics for the risky asset underlying the strategy. In either case the self-contagious nature of asset prices is not taken into account. In order to account for contagion while preserving analytical tractability, we introduce self-exciting jumps in the underlying dynamics via Hawkes processes. Within this framework we derive the loss probability when trading is performed continuously. Moreover, we estimate measures of the risk involved in the practical implementation of discrete-time rebalancing rules governing the CPPI product. When rebalancing is performed on a frequency less than weekly, failing to take contagion into account will significantly underestimate the risks of the CPPI. Finally, in order to mimic a situation with low liquidity, we impose a daily trading cap on the risky asset and find that the Hawkes process driven models give rise to the highest risk measures even under daily rebalancing.     

Time to wealth goals in capital accumulation

This paper considers the problem of investment of capital in risky assets in a dynamic capital market in continuous time. The model controls risk, and in particular the risk associated with errors in the estimation of asset returns. The framework for investment risk is a geometric Brownian motion model for asset prices, with random rates of return. The information filtration process and the capital allocation decisions are considered separately. The filtration is based on a Bayesian model for asset prices, and an (empirical) Bayes estimator for current price dynamics is developed from the price history. Given the conditional price dynamics, investors allocate wealth to achieve their financial goals efficiently over time. The price updating and wealth reallocations occur when control limits on the wealth process are attained. A Bayesian fractional Kelly strategy is optimal at each rebalancing, assuming that the risky assets are jointly lognormal distributed. The strategy minimizes the expected time to the upper wealth limit while maintaining a high probability of reaching that goal before falling to a lower wealth limit. The fractional Kelly strategy is a blend of the log-optimal portfolio and cash and is equivalently represented by a negative power utility function, under the multivariate lognormal distribution assumption. By rebalancing when control limits are reached, the wealth goals approach provides greater control over downside risk and upside growth. The wealth goals approach with random rebalancing times is compared to the expected utility approach with fixed rebalancing times in an asset allocation problem involving stocks, bonds, and cash.     

Investor sentiment and return predictability of disagreement

This study examines the influence of investor sentiment on the relationship between disagreement among investors and future stock market returns. We find that the relationship between disagreement and future stock market returns time-varies with the degree of investor sentiment. Higher disagreement among investors’ opinions predicts significantly lower future stock market returns during high-sentiment periods, but it has no significant effect on future stock market returns during low-sentiment periods. Our findings imply that investor sentiment is related to several causes of short-sale impediments suggested in the previous literature on investor sentiment, and that the stock return predictability of disagreement is driven by investor sentiment. We demonstrate that investor sentiment has a significant impact on the stock market return predictability of disagreement through in-sample and out-of-sample analyses. In addition, the profitability of our suggested trading strategy exploiting disagreement and investor sentiment level confirms the economic significance of incorporating investor sentiment into the relationship between disagreement among investors and future stock market returns.     

Abnormal investment and firm performance

We find a negative relation between abnormal investment and future stock performance. Such a negative relation is mainly driven by under-investment, not over-investment. Our results are robust to various estimation methods and investment models. Both delayed market reaction and agency issues may lead to the apparently anomalous return predictability of under-investment. First, market investors may not react promptly to the fundamental information contained in under-investment about a firm’s future profitability, asset growth, and financial distress probability. Second, the negative relation between under-investment and future stock returns is more pronounced for firms with lower investor monitoring and higher agency costs.     

Investment Horizon Effects

Abstract:   Boudry and Gray (2003) have documented that the optimal buy‐and‐hold demand for Australian stocks is not necessarily increasing in the investment horizon when returns are predictable. Such finding is in contrast with Barberis (2000) who shows that positive monotonic horizon effects predominate for US stocks. Using a closed‐form approximation to the asset allocation problem, this paper relates the return dynamics to the investor's portfolio choice for different investment horizons. In the special case of a single risky asset, it is shown that return predictability under stationarity may induce both positive and negative horizon effects in the optimal allocation to the risky asset. The paper extends previous empirical results by solving for the optimal portfolio when two risky assets with predictable returns are available for investment.     

Investor sentiment indices based on k-step PLS algorithm: A group of powerful predictors of stock market returns

We construct a group of new investor sentiment indices by applying a new dimension reduction technique called k-step algorithm which adopts partial least squares method recursively. With the purpose of forecasting the aggregate stock market return, the new group of investor sentiment indices performs a greater ability in predicting the market return than existing investor sentiment indices in and out of sample by adequately using the information in residuals and eliminating a common noise component in sentiment proxies. This group of new investor sentiment indices beats five widely used economic variables and still has a strong return predictability after controlling these variables. Moreover, they could also predict cross-sectional stock returns sorted by industry, size, value, and momentum and generate considerable economic value for a mean-variance investor. We find the predictability of this group of investor sentiment indices comes from its forecasting power for discount rates and market illiquidity.     

Stock Return Predictability and Asset Pricing Models

This article develops an asset allocation framework that incorporatesprior beliefs about the extent of stock return predictabilityexplained by asset pricing models. We find that when prior beliefsallow even minor deviations from pricing model implications,the resulting asset allocations depart considerably from andsubstantially outperform allocations dictated by either theunderlying models or the sample evidence on return predictability.Under a wide range of beliefs about model pricing abilities,asset allocations based on conditional models outperform theirunconditional counterparts that exclude return predictability.     

Dynamic nonmyopic portfolio behavior

The dynamic nonmyopic portfolio behavior of an investor whotrades a risk-free and risky asset is derived for all HARA utilityfunctions and a stochastic risk premium. Conditions are foundfor when the investor holds more or less than the myopic amountof the risky assets; hedges against or speculates the risk-premiumuncertainty; is long or short on the risky asset; and holdsmore or less of the risky asset at longer horizons. The analyticalsolutions derived take multiple mathematical forms and includeextreme cases in which investors with long but finite horizonscan attain nirvana.     

Voluntary disclosure of information when firms are uncertain of investor response

A firm may prefer not to disclose its private information if it is uncertain of investor response. In the setting under consideration, a firm needs to acquire capital from an investor. The investor can choose to invest in the firm, the risk free asset or in some alternative risky investment opportunity. It is shown that in a partial disclosure equilibrium, the firm discloses average information and withholds bad and good information. Disclosure of average information arises to attract the investor's capital away from the risk free asset.     

Investor attention,index performance,and return predictability

We investigate a link between the performance of several security indexes in broad investment categories and investor attention as measured by Google search probability. We find that there is a significant short-term change in index returns following an increase in attention. Conversely, a shock to returns leads to a long-term change in attention. Given this evidence, we hypothesize that a change in index return or the sign of its return in the past can indicate the nature of the information that investors are paying attention to. Therefore, past returns should determine the impact of attention on the future returns and volatility. Indeed, we find significant interaction effects between lagged returns and attention. This result suggests that attention can alter predictability of index returns. Specifically, we demonstrate that increased investor attention diminishes return predictability and, therefore, improves market efficiency.     

Market Response to Investor Sentiment

This paper reconsiders the effect of investor sentiment on stock prices. Our main contribution is that, in addition to the intermediate term return predictability, we also analyze the immediate price reaction to the publication of survey‐based investor sentiment indicators. We find that the sign of the immediate market response is the same as that of the predictability at intermediate time horizons. This is consistent with underreaction to cash flow news or with investor sentiment being related to mispricing. It is inconsistent with the alternative explanations of a rational response to cash flow news or sentiment indicators providing information about future expected returns.