Understanding and exploiting momentum in stock returns

The existence of a predictable component in stock returns is well documented and the ensuing autocorrelation of holding-period returns does impact optimal portfolio choice by originating strategic-asset allocation. Positive (negative) autocorrelation is a clear-cut measure of momentum (mean reversion). Return autocorrelation has motivated wellknown active portfolio-management strategies, like either ‘buy winners/sell losers’ to profit from momentum, or contrarian strategies to profit from mean reversion. These strategies are quite popular among practitioners and important in the academic assessment of the efficient markets hypothesis. However, although the asset-allocation literature has explored in depth the mean-reversion case, momentum has not received pairwise attention. The purpose of this chapter is to study the continuous-time asset-allocation problem of an investor who, given a finite time horizon, tries to exploit momentum. We focus on the characterization of her optimal demand for the risky stock. Since momentum implies a stochastic opportunity set for the investor (changes in momentum imply changes in the instantaneous conditional expected returns on the stock), we are not only interested in unveiling the active component of her speculative demand, but also in providing a thorough description of her hedging demand.