Optimality of Momentum and Reversal

52 Pages Posted: 17 Jul 2014

See all articles by Xuezhong He

Xuezhong He

University of Technology Sydney (UTS) - Finance Discipline Group, Business School; Financial Research Network (FIRN)

Kai Li

Macquarie Business School, Macquarie University

Youwei Li

Hull University Business School

Date Written: July 15, 2014

Abstract

We develop a continuous-time asset price model to capture short-run momentum and long-run reversal. By studying a dynamic asset allocation problem, we derive the optimal investment strategy in closed form and show that the combined momentum and reversal strategies are optimal. We then estimate the model to the S&P 500 and demonstrate that, by taking the timing opportunity with respect to trend in return and market volatility, the optimal strategies outperform not only pure momentum and pure mean reversion strategies, but also the market index and time series momentum strategy. Furthermore we show that the optimality also holds for the out-of-sample tests and with short-sale constraints and the outperformance is immune to market states, investor sentiment and market volatility.

Keywords: momentum, reversal, portfolio choice, optimality, profitability.

JEL Classification: G12, G14, E32

Suggested Citation

He, Xue-Zhong 'Tony' and Li, Kai and Li, Youwei, Optimality of Momentum and Reversal (July 15, 2014). Available at SSRN: https://ssrn.com/abstract=2467392 or http://dx.doi.org/10.2139/ssrn.2467392

Xue-Zhong 'Tony' He

University of Technology Sydney (UTS) - Finance Discipline Group, Business School ( email )

Haymarket
Sydney, NSW 2007
Australia

Financial Research Network (FIRN)

C/- University of Queensland Business School
St Lucia 4071 Brisbane
Queensland
Australia

HOME PAGE: http://www.firn.org.au

Kai Li (Contact Author)

Macquarie Business School, Macquarie University ( email )

Level 6 4 Eastern Road, Macquarie University
North Ryde NSW 2109
Sydney, NSW 99999
Australia
435473800 (Phone)

Youwei Li

Hull University Business School ( email )

University of Hull
Hull, HU6 7RX
United Kingdom

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