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Portfolio Choice and Equity Characteristics: Characterizing the Hedging Demands Induced by Return Predictability

  • Anthony W. Lynch
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    This paper examines portfolio allocation across equity portfolios formed on the basis of characteristics like size and book-to- market. In particular, the paper assesses the impact of return predictability on portfolio choice for a multi-period investor with a coefficient of relative risk aversion of 4. Compared to the investor’s allocation in her last period, return predictability with dividend yield causes the investor early in life to tilt her risky-asset portfolio away from high book-to-market stocks and away from small stocks. These results are explained using Merton’s (1973) characterization of portfolio allocation by a multiperiod investor in a continuous time setting. Abnormal returns relative to the investor’s optimal early-life portfolio are also calculated. These abnormal returns are found to exhibit the same cross-sectional patterns as abnormal returns calculated relative to the market portfolio: higher for small than large firms, and higher for high than low book-to-market firms. Thus, hedging demand may be a partial explanation for the high expected returns documented empirically for small firms and high book-to-market firms. However, even with this hedging demand, the investor wants to short-sell the low book-to market portfolio to hold the high book-to-market portfolio. The utility costs of using a value-weighted equity index or of ignoring predictability are also calculated. An investor using a value-weighted equity index would give up a much larger fraction of her wealth to have access to book-to-market portfolios than size portfolios. Finally, while an investor would give up a much larger fraction of her wealth to have access to dividend yield information than term spread information, term spread does have incremental benefits over and above just using dividend yield alone.

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    File URL: http://www.stern.nyu.edu/fin/workpapers/papers99/wpa99073.pdf
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    Paper provided by New York University, Leonard N. Stern School of Business- in its series New York University, Leonard N. Stern School Finance Department Working Paper Seires with number 99-073.

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    Date of creation: Feb 2000
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    Handle: RePEc:fth:nystfi:99-073
    Contact details of provider: Postal: U.S.A.; New York University, Leonard N. Stern School of Business, Department of Economics . 44 West 4th Street. New York, New York 10012-1126
    Phone: (212) 998-0100
    Web page: http://w4.stern.nyu.edu/finance/
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    23. Fama, Eugene F, 1970. "Multiperiod Consumption-Investment Decisions," American Economic Review, American Economic Association, vol. 60(1), pages 163-74, March.
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