Dynamic Portfolio Choice
July 11, 2012
The foundation for a long-term investment strategy is rebalancing to fixed asset class positions, which are determined in a one-period portfolio choice problem where the asset weights reflect the investor’s attitude toward risk. Rebalancing is a counter-cyclical strategy that has worked well even during the Great Depression in the 1930s and during the Lost Decade of the 2000s. Rebalancing goes against investors' behavioral tendencies and is also a short volatility strategy. When there are liabilities and asset returns vary over time, the long-term investor’s optimal portfolio consists of (i) a liability-hedging portfolio, (ii) a market (or myopic demand) portfolio that reflects optimal short-run asset positions, and (iii) an opportunistic (or long-term hedging demand) portfolio that allows a long-run investor to take advantage of changing investment returns.
Number of Pages in PDF File: 59
Keywords: Rebalancing, Long-horizon investing, Diversification return, Kelly rule, Ulysses contract, Short volatility strategy
JEL Classification: G11, G12, G13
Date posted: July 11, 2012