Predictability and Transaction Costs: The Impact on Rebalancing Rules and Behavior


  • Anthony W. Lynch,

  • Pierluigi Balduzzi

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    • Lynch is from New York University, and Balduzzi is from Boston College. The authors thank John Campbell, Jennifer Carpenter, George Constantinides, Ned Elton, Silverio Foresi, John Heaton, John Liew, Robert Whitelaw, and especially René Stulz (the editor) and an anonymous referee for helpful conversations and comments. Financial support from New York University Summer Research Grants is gratefully acknowledged.


Recent papers show that predictability calibrated to U.S. data has a large effect on the rebalancing behavior of a multiperiod investor. We find that this continues to be true in the presence of realistic transaction costs. In particular, predictability causes the no-trade region for the risky-asset holding to become state dependent and, on average, wider and higher. Predictability also motivates the investor to spend considerably more on rebalancing and to rebalance more often. In other results, we find that introducing costly liquidation of the risky asset for consumption lowers the average allocation to the risky asset, though only marginally early in life. Our experiments also vary the nature of the return predictability and introduce return heteroskedasticity.