Download This PaperTiming Idiosyncratic Volatility and Dynamic Asset Allocation
56 Pages Posted: 12 May 2020 Last revised: 9 Jun 2020
Date Written: April 19, 2020
Abstract
We solve a portfolio selection problem when both expected return, idiosyncratic volatility, and transaction cost are time-varying. Our optimal strategy suggests trading partially toward a dynamic aim portfolio, which is a weighted average of expected future tangency portfolio and is highly influenced by the common fluctuation of idiosyncratic volatility (CIV). When CIV is high, the investor would invest less and trade less frequently to avoid risk and transaction cost. Moreover, the investor trades more closely to the aim portfolio with a more persistent CIV signal. Our strategy outperforms alternative strategies empirically and the benefits mainly come from timing idiosyncratic volatility
Keywords: Idiosyncratic volatility, dynamic asset allocation, transaction cost, return predictability, volatility timing
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