Portfolio Rebalancing in General Equilibrium.” Working paper

This paper develops an overlapping generations model of optimal rebalancing in which agents differ both in age and risk tolerance. Equilibrium rebalancing is driven by a leverage effect that influences levered and unlevered agents in opposite directions, an aggregate risk tolerance effect which depends on the distribution of wealth, and an intertemporal hedging effect. The model shows that relatively risk tolerant investors optimally engage in return chasing behavior while more risk averse investors behave in a contrarian fashion. Contrary to conventional wisdom, price and wealth effects make it optimal for all agents to increase their exposure to the risky asset after a negative shock and to decrease their exposure after a positive shock