Multi-period portfolio selection with drawdown control

Peter Nystrup*, Stephen Boyd, Erik Lindström, Henrik Madsen

*Corresponding author for this work

Research output: Contribution to journalJournal articleResearchpeer-review

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Abstract

In this article, model predictive control is used to dynamically optimize an investment portfolio and control drawdowns. The control is based on multi-period forecasts of the mean and covariance of financial returns from a multivariate hidden Markov model with time-varying parameters. There are computational advantages to using model predictive control when estimates of future returns are updated every time new observations become available, because the optimal control actions are reconsidered anyway. Transaction and holding costs are discussed as a means to address estimation error and regularize the optimization problem. The proposed approach to multi-period portfolio selection is tested out of sample over two decades based on available market indices chosen to mimic the major liquid asset classes typically considered by institutional investors. By adjusting the risk aversion based on realized drawdown, it successfully controls drawdowns with little or no sacrifice of mean–variance efficiency. Using leverage it is possible to further increase the return without increasing the maximum drawdown.

Original languageEnglish
JournalAnnals of Operations Research
Volume282
Issue number1-2
Pages (from-to)245-271
Number of pages27
ISSN0254-5330
DOIs
Publication statusPublished - 2019

Keywords

  • Risk management
  • Maximum drawdown
  • Dynamic asset allocation
  • Model predictive control
  • Regime switching
  • Forecasting

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