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Dynamic Portfolio Choice with Parameter Uncertainty and the Economic Value of Analysts' Recommendations

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Listed:
  • Jakša Cvitanić
  • Ali Lazrak
  • Lionel Martellini
  • Fernando Zapatero

Abstract

We derive a closed-form solution for the optimal portfolio of a nonmyopic utility maximizer who has incomplete information about the alphas or abnormal returns of risky securities. We show that the hedging component induced by learning about the expected return can be a substantial part of the demand. Using our methodology, we perform an "ex ante" empirical exercise, which shows that the utility gains resulting from optimal allocation are substantial in general, especially for long horizons, and an "ex post" empirical exercise, which shows that analysts' recommendations are not very useful. (JEL C61, G11, G24) Copyright 2006, Oxford University Press.

Suggested Citation

  • Jakša Cvitanić & Ali Lazrak & Lionel Martellini & Fernando Zapatero, 2006. "Dynamic Portfolio Choice with Parameter Uncertainty and the Economic Value of Analysts' Recommendations," Review of Financial Studies, Society for Financial Studies, vol. 19(4), pages 1113-1156.
  • Handle: RePEc:oup:rfinst:v:19:y:2006:i:4:p:1113-1156
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    References listed on IDEAS

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    Cited by:

    1. Lundtofte, Frederik, 2008. "Expected life-time utility and hedging demands in a partially observable economy," European Economic Review, Elsevier, pages 1072-1096.
    2. Michele Longo & Alessandra Mainini, 2017. "Welfare effects of information and rationality in portfolio decisions under parameter uncertainty," Papers 1709.04387, arXiv.org.
    3. Lubos Pastor & Pietro Veronesi, 2009. "Learning in Financial Markets," Annual Review of Financial Economics, Annual Reviews, vol. 1(1), pages 361-381, November.
    4. Palczewski, Jan & Poulsen, Rolf & Schenk-Hoppé, Klaus Reiner & Wang, Huamao, 2015. "Dynamic portfolio optimization with transaction costs and state-dependent drift," European Journal of Operational Research, Elsevier, vol. 243(3), pages 921-931.
    5. Jin-Ray Lu & Chih-Ming Chan & Wen-Shen Li, 2011. "Portfolio Selections with Innate Learning Ability," International Journal of Business and Economics, College of Business and College of Finance, Feng Chia University, Taichung, Taiwan, vol. 10(3), pages 201-217, December.
    6. Wachter, Jessica A. & Warusawitharana, Missaka, 2009. "Predictable returns and asset allocation: Should a skeptical investor time the market?," Journal of Econometrics, Elsevier, pages 162-178.
    7. Luca Benzoni & Pierre Collin-Dufresne & Robert S. Goldstein, 2007. "Portfolio Choice over the Life-Cycle when the Stock and Labor Markets Are Cointegrated," Journal of Finance, American Finance Association, vol. 62(5), pages 2123-2167, October.
    8. Nina Boyarchenko & Mario Cerrato & John Crosby & Stewart Hodges, 2012. "No good deals—no bad models," Staff Reports 589, Federal Reserve Bank of New York.
    9. Albagli, Elias, 2015. "Investment horizons and asset prices under asymmetric information," Journal of Economic Theory, Elsevier, vol. 158(PB), pages 787-837.
    10. Nicole Bauerle & Stefanie Grether, 2017. "Extremal Behavior of Long-Term Investors with Power Utility," Papers 1703.04423, arXiv.org, revised Jun 2017.
    11. Lioui, Abraham, 2013. "Time consistent vs. time inconsistent dynamic asset allocation: Some utility cost calculations for mean variance preferences," Journal of Economic Dynamics and Control, Elsevier, vol. 37(5), pages 1066-1096.
    12. repec:spr:compst:v:71:y:2010:i:2:p:371-399 is not listed on IDEAS
    13. Peng W. He & Andrew Grant & Joel Fabre, 2013. "Economic value of analyst recommendations in Australia: an application of the Black–Litterman asset allocation model," Accounting and Finance, Accounting and Finance Association of Australia and New Zealand, vol. 53(2), pages 441-470, June.
    14. Lu, Jin-Ray & Hwang, Chih-Chiang & Liu, Min-Luan & Lin, Chien-Yi, 2016. "An incentive problem of risk balancing in portfolio choices," The Quarterly Review of Economics and Finance, Elsevier, vol. 61(C), pages 192-200.
    15. Michele Longo & Alessandra Mainini, 2016. "Learning And Portfolio Decisions For Crra Investors," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 19(03), pages 1-21, May.
    16. Tomas Björk & Mark Davis & Camilla Landén, 2010. "Optimal investment under partial information," Mathematical Methods of Operations Research, Springer;Gesellschaft für Operations Research (GOR);Nederlands Genootschap voor Besliskunde (NGB), vol. 71(2), pages 371-399, April.
    17. JULES H. van BINSBERGEN & MICHAEL W. BRANDT & RALPH S. J. KOIJEN, 2008. "Optimal Decentralized Investment Management," Journal of Finance, American Finance Association, vol. 63(4), pages 1849-1895, August.
    18. Bradford Cornell & Jakša Cvitanić & Levon Goukasian, 2010. "Beliefs regarding fundamental value and optimal investing," Annals of Finance, Springer, pages 83-105.
    19. repec:wsi:ijtafx:v:20:y:2017:i:05:n:s0219024917500297 is not listed on IDEAS
    20. Andrea M. Buffa & Suleyman Basak, 2016. "A Theory of Operational Risk," 2016 Meeting Papers 352, Society for Economic Dynamics.
    21. Florian Esterer & David Schröder, 2014. "Implied cost of capital investment strategies: evidence from international stock markets," Annals of Finance, Springer, pages 171-195.
    22. Michele Longo & Alessandra Mainini, 2015. "Learning and Portfolio Decisions for HARA Investors," Papers 1502.02968, arXiv.org.
    23. Zvi Bodie & Jérôme Detemple & Marcel Rindisbacher, 2009. "Life-Cycle Finance and the Design of Pension Plans," Annual Review of Financial Economics, Annual Reviews, vol. 1(1), pages 249-286, November.
    24. Elías Albagli, 2013. "Investment Horizons and Asset Prices under Asymmetric Information," Working Papers Central Bank of Chile 709, Central Bank of Chile.

    More about this item

    JEL classification:

    • C61 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Optimization Techniques; Programming Models; Dynamic Analysis
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G24 - Financial Economics - - Financial Institutions and Services - - - Investment Banking; Venture Capital; Brokerage

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