Long-Term Asset Allocation, Risk Tolerance and Market Sentiment

Abstract

This paper studies optimal equity portfolios with long-term horizon under heterogeneous risk aversion levels. We focus on European stocks and empirically show that contemporaneous excess returns of semi-active strategies are negatively associated with market conditions and sentiment. Consistent with our long-horizon perspective, we find that the effects of sentiment measures on semi-active portfolio returns are sizeable and economically relevant, particularly in bull (post-crisis) periods, even after controlling for the five Fama-French factors, momentum, macro indicators and political uncertainty shocks either globally or country-wise. By contrast, the effects of sentiment measures on the passive (benchmark) portfolio are negligible. The results further indicate that realized portfolio returns generated from our long-term strategies are considerably resilient to the episodes of flight-to-safety (risk-off) regimes.

Keywords: Asset management, Portfolio choice, Investment horizons, Investor and market sentiment, Fund performance, Signal processing

JEL Classification: C61, D81, G11, G12, G14