Optimal Investment Portfolios with Predictable Return Signs

Abstract

Expected returns of assets are notoriously difficult to estimate. Instead, investors typically have views on the mere directions of price changes, that is, whether assets are undervalued or overvalued. This paper examines how directional views affect the investor’s portfolio choice: We show that the investor prefers assets with high volatility for higher expected returns, dislikes negative return correlation between assets, and that the covariance between magnitudes of returns matters explicitly for portfolio variance. In addition, the introduced approach to portfolio selection can produce notably higher Sharpe ratios and geometric means compared to a naive alternative.