Bubbles and Investment Horizons

Posted: 9 Oct 2009 Last revised: 3 Nov 2009

See all articles by Nadja Guenster

Nadja Guenster

University of Muenster - Finance Center Muenster; University of California, Berkeley

Erik Kole

Erasmus University Rotterdam - Erasmus School of Economics - Econometric Institute; ERIM; Tinbergen Institute

Date Written: June 15, 2009

Abstract

The current theoretical literature makes contradicting predictions regarding the impact of an investor’s horizon on his optimal trading strategy in the presence of bubbles. We analyze this relation empirically using a Regime Switching Model to identify bubbles and crashes. We base our analysis on industry returns and find high positive returns after bubbles at the one-month horizon. At intermediate horizons of 2-4 months our findings are mixed, but thereafter, for horizons up to five years, returns following a bubble are again more positive than returns in the absence of a bubble. We compare a mean-variance as well as a downside-risk averse investor’s portfolio allocation in the presence and absence of a bubble. The weight allocated to the bubbly asset is higher for horizons up to 5 years. These findings suggest that even for a rather unsophisticated trader who does not follow daily market news, riding bubbles is a more profitable strategy than refraining from investing in the bubbly asset. Given the broad range of horizons during which riding bubbles is the optimal strategy, our results question the idea that bubbles are zero-sum games.

Keywords: bubbles, limits-to-arbitrage, feedback, regime switching

JEL Classification: G14, G11, C13

Suggested Citation

Guenster, Nadja and Kole, Erik, Bubbles and Investment Horizons (June 15, 2009). Paris December 2009 Finance International Meeting AFFI - EUROFIDAI, Available at SSRN: https://ssrn.com/abstract=1484577

Nadja Guenster

University of Muenster - Finance Center Muenster ( email )

Universitatsstr. 14-16
Muenster, 48143
Germany

University of California, Berkeley ( email )

310 Barrows Hall
Berkeley, CA 94720
United States

Erik Kole (Contact Author)

Erasmus University Rotterdam - Erasmus School of Economics - Econometric Institute ( email )

P.O. Box 1738
3000 DR Rotterdam
Netherlands
+31 10 408 12 58 (Phone)

HOME PAGE: http://people.few.eur.nl/kole

ERIM

P.O. Box 1738
3000 DR Rotterdam
Netherlands

Tinbergen Institute ( email )

Burg. Oudlaan 50
Rotterdam, 3062 PA
Netherlands

HOME PAGE: http://people.few.eur.nl/kole

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