Gradual Portfolio Adjustment: Implications for Global Equity Portfolios and Returns

Abstract

Modern open economy macro models assume the continuous adjustment of international portfolio allocation. We introduce gradual portfolio adjustment into a global equity market model. Our approach differs from related literature in two key dimensions. First, the time interval between portfolio decisions is stochastic rather than fixed, leading to a smoother response to shocks. Second, rather than only considering asset returns, we also use data on portfolio shares to confront the model to the data. Conditional on reasonable risk aversion, we find that the data is consistent with infrequent portfolio decisions, with a frequency of at most once in 15 months on average.

International Portfolio Choice with Frictions: Evidence from Mutual Funds

“…Froot and Thaler (1990), in attempting to explain the forward discount puzzle of excess return predictability in the foreign exchange market, hypothesize that "...at least some investors are slow in responding to changes in the interest differential." More formally, Bacchetta and van Wincoop (2010, 2021), Bacchetta, Davenport and van Wincoop (2022), and Bacchetta, van Wincoop and Young (2023) show that open economy models with portfolio frictions can explain a variety of evidence related to excess return predictability in foreign exchange and equity markets as well as various data moments involving capital flows, saving, investment and aggregate US equity portfolios. 2 Nonetheless none of the existing literature has provided direct evidence of portfolio frictions in international portfolio allocation data.…”