Momentum and Mean-Reversion in Strategic Asset Allocation
34 Pages Posted: 7 Jun 2006 Last revised: 28 Jan 2009
Date Written: January 27, 2009
We study a dynamic asset allocation problem in which stock returns exhibit short-run momentum and long-run mean reversion. We develop a tractable continuous-time model that captures these two predictability features and derive the optimal investment strategy in closed-form. The model predicts negative hedging demands for medium-term investors, and an allocation to stocks that is non-monotonic in the investor's horizon. Momentum substantially increases the economic value of hedging time-variation in investment opportunities. These utility gains are preserved when we impose realistic borrowing and short-sales constraints and allow the investor to trade on a monthly frequency.
Keywords: Return predictability, Momentum, Mean reversion, Portfolio choice
JEL Classification: G0, G11, G12
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