This paper examines portfolio allocation across equity portfolios formed on the basis of characteristics like size and book-to-market. In particular, the paper assesses the impact of return predictability on portfolio choice for a multi-period investor with a coefficient of relative risk aversion of 4. Compared to the investor's allocation in her last period, return predictability with dividend yield causes the investor early in life to tilt her risky-asset portfolio away from high book-to-market stocks and away from small stocks. These results are explained using Merton's (Econometrica 41 (1973) 867) characterization of portfolio allocation by a multi-period investor in a continuous time setting. Abnormal returns relative to the investor's optimal early life portfolio are also calculated. These abnormal returns are found to exhibit the same cross-sectional patterns as abnormal returns calculated relative to the market portfolio: higher for small rather than large firms, and higher for high rather than low book-to-market firms. Thus, hedging demand may be a partial explanation for the high expected returns documented for small firms and high book-to-market firms. However, even with this hedging demand, the investor wants to sell short the low book-to market portfolio to hold the high book-to-market portfolio. The utility costs of using a value-weighted equity index or of ignoring predictability are also calculated. An investor using a value-weighted equity index would give up a much larger fraction of her wealth to have access to book-to-market portfolio than size portfolios. Finally, an investor would give up a much larger fraction of her wealth to have access to dividend yield information than term spread information.

This article examines a model in which decisions are made at fixed intervals and are unsynchronized across agents. Agents choose nondurable consumption and portfolio composition, and either or both can be chosen infrequently. A small utility cost is associated with both decisions being made infrequently. Calibrating returns to the U.S. economy, less frequent and unsynchronized decision‐making delivers the low volatility of aggregate consumption growth and its low correlation with equity return found in U.S. data. Allowing portfolio rebalancing to occur every period has a negligible impact on the joint behavior of aggregate consumption and returns.

We simulate standard tests of performance persistence using alternative return-generating processes, survival criteria, and test methodologies. When survival depends on performance over several periods, survivorship bias induces spurious reversals, despite the presence of cross-sectional heteroskedasticity in performance. Look-ahead biased methodologies and missing final returns typical of U.S. mutual fund datasets can also materially affect persistence measures. Our results reinforce previous findings that U.S. mutual fund performance is truly persistent. When fund performance is truly persistent, fund attrition affects persistence measures, even when the sample includes all nonsurvivor returns. We also examine the specification and power of the various persistence tests.

Constantinides (1986) documents how the impact of transaction costs on per‐annum liquidity premia in the standard dynamic allocation problem with i.i.d. returns is an order of magnitude smaller than the cost rate itself. Recent papers form portfolios sorted on liquidity measures and find spreads in expected per‐annum return that are the same order of magnitude as the transaction cost spread. When we allow returns to be predictable and introduce wealth shocks calibrated to labor income, transaction costs are able to produce per‐annum liquidity premia that are the same order of magnitude as the transaction cost spread.

We find that the Campbell–Cochrane external-habit model can generate a value premium if the persistence of the consumption surplus is sufficiently low. Such low persistence is supported by micro evidence on consumption. If the mean and conditional volatility of consumption growth are highly persistent, as in the Bansal–Yaron long-run risk model, then fast-moving habit can also generate, without eroding the value premium: i) empirically sensible long horizon return predictability; and ii) a price–dividend ratio for market equity that exhibits the high autocorrelation found in the data. Fast-moving habit also delivers several empirical properties of market-dividend strips.

This paper describes estimation methods, based on the generalized method of moments (GMM), applicable in settings where time series have different starting or ending dates. We introduce two estimators that are more efficient asymptotically than standard GMM. We apply these to estimating predictive regressions in international data and show that the use of the full sample affects inference for assets with data available over the full period as well as for assets with data available for a subset of the period. Monte Carlo experiments demonstrate that reductions hold for small-sample standard errors as well as asymptotic ones.

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.