A Rational Foundation for Trend-Chasing and Contrarian Trades with Implications for Momentum Anomalies

Trend-chasing and Contrarian are well-documented empirical trading patterns that the literature generally attributes to behavioral biases. In contrast, we argue that both are rational portfolio rebalancing strategies in a dynamic asset allocation framework. Analyzing the interactions between strategies implemented in stocks and bonds, we find that a key parameter is the investor's level of relative-risk-aversion versus the market price of risk. Our mapping of preferences to trades fits remarkably well recent empirical findings of time-series momentum and reversal. Specifically, speculators trade like Trend-chasers throughout the momentum phase closing positions once the trend reverses, while hedgers trade like Contrarians. These trades seem to explain time-series momentum.