Optimal Trading in Correlated Anomalies

35 Pages Posted: 6 Sep 2017 Last revised: 24 Jun 2023

Date Written: March 18, 2020

Abstract

The empirical asset pricing literature documents a myriad of anomalies. Accounting for the correlated and mean-reverting nature of these anomalies, I provide an explicit solution to the optimal dynamic investment problem of a risk-averse investor who trades in an arbitrary number of potentially mispriced assets. The solution can be characterized in terms of a passive and an active portfolio, where the active positions respond to market-timing and stock-selection considerations. Mispricing risk can have a large impact on the investor's optimal portfolio, which the investor hedges by increasing the size of the position in the mispriced asset. When the market portfolio is subject to mispricing, market-timing and stock-selection considerations interact to determined the optimal position in each asset. I show that diversification considerations can lead the investor to optimally take a positive active position in an overpriced asset, and even to increase the allocation in this asset as overpricing worsens. These results have important positive and normative implications.

Keywords: Asset allocation, market timing, stock selection, asset mispricing, mean reversion

JEL Classification: D81, D83, G11, G12

Suggested Citation

Sotes-Paladino, Juan M., Optimal Trading in Correlated Anomalies (March 18, 2020). Available at SSRN: https://ssrn.com/abstract=3030796 or http://dx.doi.org/10.2139/ssrn.3030796

Juan M. Sotes-Paladino (Contact Author)

Universidad de los Andes, Chile ( email )

Chile

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