Infrequent Random Portfolio Decisions in an Open Economy Model.

This article introduces a portfolio friction in a two-country dynamic stochastic general equilibrium (DSGE) model, where investors face a constant probability of making new portfolio decisions, leading to infrequent portfolio adjustments. This friction generates portfolio inertia and a weaker, more gradual response to expected excess returns, aligning the model more closely with empirical evidence from US and global equity markets. Calibrated to monthly data for the US and the rest of the world, the model with an intermediate friction level (probability of portfolio revision around 0.1) successfully replicates observed features such as limited sensitivity to expected excess returns, significant price impact of financial shocks, excess return predictability, and asset price momentum and reversal. In contrast, frictionless models (with continuous portfolio adjustment) fail to capture these phenomena, implying unrealistically high sensitivity to expected returns, weak price impact of financial shocks, and absence of momentum and reversal patterns. The study thus highlights the importance of incorporating infrequent portfolio decisions to better understand international portfolio allocation, asset prices, and excess return dynamics.