Beliefs Regarding Fundamental Value and Optimal Investing * Bradford Cornell † Jakˇ sa Cvitani´ c ‡ Levon Goukasian § June 4, 2008 Abstract We derive optimal portfolio weights for an investor who has specific beliefs regarding the distribution of a stock price at a future time. For example, a fundamental investor will want to take advantage of the information his analysis provides when constructing a portfolio. In this regard, we examine the optimal weights for models in which the investor believes that there is a range in which the price is likely to remain. Under such circumstances, the optimal strategy is to take significant long/short positions as the price nears its lower/upper boundary. The risk, expected stock return and the optimal investment strategy are thus dependent on the stock price relative to the boundaries. Keywords: Investor beliefs, mispricing, optimal portfolios, range reversion, risk premium. JEL Classification: G11 * The previous version of this paper was circulated under the title “Optimal investing with perceived mispricing”. J.C.’s research supported in part by NSF grants DMS 04-03575 and DMS 06-31298, and through the Programme ”GUEST” of the National Foundation For Science, Higher Education and Technological Development of the Republic of Croatia. We are solely responsible for any remaining errors, and the opinions, findings and conclusions or suggestions in this article do not necessarily reflect anyone’s opinions but the authors’. † Caltech, Humanities and Social Sciences, M/C 228-77, 1200 E. California Blvd. Pasadena, CA 91125. Ph: (626) 833-9978. E-mail: bcornell@hss.caltech.edu ‡ Caltech, Humanities and Social Sciences, M/C 228-77, 1200 E. California Blvd. Pasadena, CA 91125. Ph: (626) 395-1784. E-mail: cvitanic@hss.caltech.edu. § Business Division, Pepperdine University, Malibu, CA 90263. Ph: (310) 506-4425. E-mail: Levon.Goukasian@Pepperdine.edu. 1