Anthony W. Lynch, Pierluigi Balduzzi
ABSTRACT
We consider the impact of transaction costs on the portfolio decisions of
a long-lived agent with isoelastic preferences. In particular, we focus
on how portfolio choice, rebalancing frequency and average cost incurred
change over the lifecycle are affected by return predictability. Two
types of costs are evaluated: proportional to the change in the holding of
the risky asset and a fixed fraction of portfolio value. We find that
realistic transaction costs can materially affect rebalancing behavior,
creating no-trade regions that widen near the investor's terminal date.
At the same time, realistic proportional and fixed costs have little
effect on the midpoint of the no-trade region, unless liquidation costs
differ across assets. Return predictability calibrated to U.S. stock
returns is found to have large effects on rebalancing behavior relative to
independent and identically distributed (i.i.d.) returns with the same
unconditional distribution. For example, return predictability causes
rebalancing frequency to increase, and cost incurred to increase by an
order of magnitude, at all points in the investor's life. No-trade
regions early in life are wider when returns are predictable than when
they are not. Finally, we find that the nature of the return
predictability, including the presence or not of return
heteroscedasticity, can have large effects on rebalancing behavior.
Subject: Investments/Portfolio Choice, Investments/Predictability of Asset Returns (Theoretical)
Lynch: (212) 998-0350 alynch@stern.nyu.edu
Balduzzi: (617) 552-3976 balduzzp@bc.edu
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