Harvesting Excess Volatility

Abstract

I investigate the volatility pumping intuition in a simple discrete time version of Luenberger[1998]. The literature argues that investors can benefit from volatility by rebalancing positions to constant weights, thereby trading against past returns. I analyze the pay-off of the trading policy induced by rebalancing to understand its return and risk benefits. When returns are i.i.d., the rebalanced portfolio underperforms in expectation its buy-and-hold counterpart so that the trading benefits have to be risk based. I demonstrate analytically that to improve the expected relative return, prices have to exhibit excess volatility. Mean reversion is needed to make volatility pumping a reality for investors.