Optimal Asset Allocation with Heterogeneous Persistent Shocks and Myopic and Intertemporal Hedging Demand

Domenica Di Virgilio, Fulvio Ortu, Federico Severino and Claudio Tebaldi

Chapter 4 in Behavioral Finance:The Coming of Age, 2019, pp 57-108 from World Scientific Publishing Co. Pte. Ltd.

Abstract: There is a wide evidence that financial time series are the outcome of the superposition of processes with heterogeneous frequencies. This is true, in particular, for market return. Indeed, log market return can be decomposed into uncorrelated components that explain the reaction to shocks with different persistence. The instrument that allows us to do so is the Extended Wold Decomposition of Ortu et al. (2017). In this chapter, we construct portfolios of these components in order to maximize the utility of an agent with a fixed investment horizon. In particular, we build upon Campbell and Viceira (1999) solution of the optimal consumption-investment problem with Epstein–Zin utility, using a rebalancing interval of 2J periods. It turns out that the optimal asset allocation involves all the persistent components of market log return up to scale J. Such components play a fundamental role in characterizing both the myopic and the intertemporal hedging demand. Moreover, the optimal policy prescribes an increasing allocation on more persistent securities when the investor’s relative risk aversion rises. Finally, portfolio reallocation every 2J periods is consistent with rational inattention. Indeed, observing assets value is costly and transaction costs make occasional rebalancing optimal.

Keywords: Behavioral Economics; Behavioral Finance; Behavioral Macro-Finance; Decision Making; Disposition Effect; Financial Crisis; Financial Decision-Making; Financial Market Anomalies; Fintech; Gender Differences; Heuristics; Information Processing Style; International Contagion Market Design; Monetary Policy; Mood; Optimal Portfolio; Overreaction; Peer-to-Peer Lending; Political Economics; Time Pressure; Transparency (search for similar items in EconPapers)
JEL-codes: G30 G41 (search for similar items in EconPapers)
Date: 2019
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