Momentum in strategic asset allocation

This paper explores a continuous-time intertemporal consumption and portfolio choice problem for an infinite horizon investor with recursive utility defined over consumption. The investor who tries to exploit momentum is assumed to have access to a risk-free asset and a risky asset whose return exhibits short run momentum. We derive an exact explicit solution and an approximate analytical solution to the dynamic asset allocation problem. We find that the optimal portfolio demand for stocks contains two components: the “momentum-adjusted” myopic demand and the intertemporal hedging demand. When the model is calibrated to Chinese stock market data, it implies that intertemporal hedging demand motives greatly decrease the portfolio demand for stocks by investors whose risk aversion coefficients exceed one when the latest levels of stock returns are non-negative or moderate negative. In addition, hedging motives increase the optimal portfolio when they are sufficiently negative. Also, we find that risk aversion is the main preference parameter in determining portfolio choice rather than the elasticity of intertemporal substitution.