Skip to main content

Dynamic portfolio optimization with transaction costs: Heuristics and dual bounds

Publication ,  Journal Article
Brown, DB; Smith, JE
Published in: Management Science
October 1, 2011

We consider the problem of dynamic portfolio optimization in a discrete-time, finite-horizon setting. Our general model considers risk aversion, portfolio constraints (e.g., no short positions), return predictability, and transaction costs. This problem is naturally formulated as a stochastic dynamic program. Unfortunately, with nonzero transaction costs, the dimension of the state space is at least as large as the number of assets, and the problem is very difficult to solve with more than one or two assets. In this paper, we consider several easy-to-compute heuristic trading strategies that are based on optimizing simpler models. We complement these heuristics with upper bounds on the performance with an optimal trading strategy. These bounds are based on the dual approach developed in Brown et al. (Brown, D. B., J. E. Smith, P. Sun. 2009. Information relaxations and duality in stochastic dynamic programs. Oper. Res. 58(4) 785-801). In this context, these bounds are given by considering an investor who has access to perfect information about future returns but is penalized for using this advance information. These heuristic strategies and bounds can be evaluated using Monte Carlo simulation. We evaluate these heuristics and bounds in numerical experiments with a risk-free asset and 3 or 10 risky assets. In many cases, the performance of the heuristic strategy is very close to the upper bound, indicating that the heuristic strategies are very nearly optimal. © 2011 INFORMS.

Duke Scholars

Altmetric Attention Stats
Dimensions Citation Stats

Published In

Management Science

DOI

EISSN

1526-5501

ISSN

0025-1909

Publication Date

October 1, 2011

Volume

57

Issue

10

Start / End Page

1752 / 1770

Related Subject Headings

  • Operations Research
  • 46 Information and computing sciences
  • 38 Economics
  • 35 Commerce, management, tourism and services
  • 15 Commerce, Management, Tourism and Services
  • 08 Information and Computing Sciences
 

Citation

APA
Chicago
ICMJE
MLA
NLM
Brown, D. B., & Smith, J. E. (2011). Dynamic portfolio optimization with transaction costs: Heuristics and dual bounds. Management Science, 57(10), 1752–1770. https://doi.org/10.1287/mnsc.1110.1377
Brown, D. B., and J. E. Smith. “Dynamic portfolio optimization with transaction costs: Heuristics and dual bounds.” Management Science 57, no. 10 (October 1, 2011): 1752–70. https://doi.org/10.1287/mnsc.1110.1377.
Brown DB, Smith JE. Dynamic portfolio optimization with transaction costs: Heuristics and dual bounds. Management Science. 2011 Oct 1;57(10):1752–70.
Brown, D. B., and J. E. Smith. “Dynamic portfolio optimization with transaction costs: Heuristics and dual bounds.” Management Science, vol. 57, no. 10, Oct. 2011, pp. 1752–70. Scopus, doi:10.1287/mnsc.1110.1377.
Brown DB, Smith JE. Dynamic portfolio optimization with transaction costs: Heuristics and dual bounds. Management Science. 2011 Oct 1;57(10):1752–1770.

Published In

Management Science

DOI

EISSN

1526-5501

ISSN

0025-1909

Publication Date

October 1, 2011

Volume

57

Issue

10

Start / End Page

1752 / 1770

Related Subject Headings

  • Operations Research
  • 46 Information and computing sciences
  • 38 Economics
  • 35 Commerce, management, tourism and services
  • 15 Commerce, Management, Tourism and Services
  • 08 Information and Computing Sciences