Behavioral Finance for Private Banking, 2nd Edition

CHAPTER 8Dynamic Asset Allocation

We have seen how to find the optimal asset allocation for different investors. In this chapter, we will discuss whether and how the asset allocation changes over time. We will answer the following two questions:

1. Does the length of the investment horizon matter for the optimal asset allocation? For example, should younger investors (with a longer investment horizon) hold more risky assets than older investors?
2. Should investors care about the ups and downs of the markets? How should they adjust their asset allocation optimally to the market movements?

In the theoretical literature, we find clear answers to these questions. Two of the best‐known theorists in economics and in finance, the Nobel Laureates Paul Samuelson and Robert Merton, prove the “No time diversification theorem” (Merton, 1969; Samuelson, 1969)—that is, that in an efficient market, asset allocation is independent of the investment horizon.¹ Moreover, in this case the optimal response to the ups and downs of the efficient market is to hold the proportions of the asset allocation fixed (i.e., to rebalance). A market is efficient when it is not predictable—that is, the odds of having a good or a bad market in the future are independent from the past. Rebalancing implies that one should buy more of those assets that depreciated while those appreciating should be sold so that along the investment process one holds the percentage of wealth invested in the various asset classes fixed. ...