February 2000
Anthony W. Lynch
ABSTRACT
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.
Lynch: (212) 998-0350 alynch@stern.nyu.edu
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