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Timing Idiosyncratic Volatility and Dynamic Asset Allocation

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  • Shi, Yun

Abstract

We solve a portfolio selection problem when both expected return, idiosyncratic volatility, and transaction cost are time-varying. Our optimal strategy suggests trading partially toward a dynamic aim portfolio, which is a weighted average of expected future tangency portfolio and is highly influenced by the common fluctuation of idiosyncratic volatility (CIV). When CIV is high, the investor would invest less and trade less frequently to avoid risk and transaction cost. Moreover, the investor trades more closely to the aim portfolio with a more persistent CIV signal. Our strategy outperforms alternative strategies empirically and the benefits mainly come from timing idiosyncratic volatility.

Suggested Citation

  • Shi, Yun, 2020. "Timing Idiosyncratic Volatility and Dynamic Asset Allocation," SocArXiv 9kber_v1, Center for Open Science.
    • Handle: RePEc:osf:socarx:9kber_v1
    DOI: 10.31219/osf.io/9kber_v1
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