Abstract
This paper investigates a multi-period investment problem in which an investor revises investment decisions at the beginning of each period. The objective is to maximize expected terminal wealth while simultaneously minimizing risk. This study quantifies risk using a dynamic risk function grounded in the minimax risk diversification principle. A key feature of the model is its flexibility: in each period, the investor constructs the risk function using either standard deviation, absolute deviation, or lower semi-absolute deviation, thereby accommodating diverse risk preferences. By employing dynamic programming, analytical solutions for the optimal investment strategy are derived. These solutions explicitly demonstrate the strategy’s dependence on the expected return rates of risky assets and the investor’s risk tolerance.
MSC:
91-10
1. Introduction
Portfolio selection is the process of allocating wealth to a set of assets to achieve the best possible trade-off between expected return and risk. The mean-variance model, introduced in Markowitz’s seminal work [1], established the foundation of Modern Portfolio Theory and later earned its author the Nobel Prize. Nevertheless, the practical application of the mean-variance model to large-scale portfolios remains limited, despite its theoretical acclaim. The formidable computational complexity of solving large-scale quadratic programming problems is a major obstacle (see Leung et al. [2] and Sun et al. [3]). The size of the covariance matrix grows quadratically with the number of assets, creating a dense structure that imposes significant computational costs.
To alleviate the computational challenges, Konno and Yamazaki [4] introduced the mean-absolute deviation model, which replaces the quadratic objective with a linear one. An advantage of this linear programming is that the resulting optimization problem is computationally tractable and its implementation is analogous to that of the mean-variance model. Guided by the concept of absolute deviation for risk measurement, Cai et al. [5] introduced a minimax risk function for a no-short-selling portfolio. By exploiting the special structure of this risk function, they derived explicit analytical solutions for the optimal portfolios, thereby enabling the entire efficient frontier to be plotted. Extending absolute deviation, Rockafellar et al. [6] introduced the generalized deviation measure. Meng et al. [7] then leveraged this measure to generalize the risk function of Cai et al. [5], formulating a portfolio model that allows for short selling. They also obtained closed-form solutions for the efficient frontier and optimal portfolios.
The aforementioned models are all predicated on a single-period investment horizon. However, portfolio strategies are typically multi-period in practice. This is because contemporary financial decisions require models that reflect an interdependent and complex reality. Over longer investment horizons, economic conditions can change significantly, necessitating periodic portfolio rebalancing in response to these shifts. Consequently, extending the single-period portfolio selection framework to a multi-period setting is a natural progression.
Mossin [8] pioneered the use of dynamic programming for optimal multi-period portfolio selection. Li and Ng [9] applied this approach to the mean-variance formulation, deriving analytical expressions for the optimal strategy. Building on this, Yu et al. [10,11,12] generalized the model of Cai et al. [5] to a multi-period framework where an investor maximizes terminal wealth while minimizing total risk, defined as the sum of each asset’s maximum absolute deviation over time. They also derived a closed-form optimal policy via dynamic programming.
Building upon the multi-period framework established by Yu et al. [10], this paper seeks to extend the model of Meng et al. [7] into a multi-period context. The primary contributions are threefold. First, in contrast to the single-period model in Meng et al. [7] and the multi-period models with uniform risk measures in [10], our framework introduces a flexible risk structure. This allows investors to select a specific deviation measure, such as standard deviation, absolute deviation, or lower semi-absolute deviation for each period, enabling a more dynamic and personalized approach to risk management. Second, by leveraging dynamic programming, we derive a general closed-form solution for the optimal investment strategy. This analytical result not only simplifies implementation but also provides clear insights into how the strategy is influenced by the assets’ expected returns and the investor’s risk tolerance. Third, we provide explicit necessary and sufficient conditions for the risk tolerance parameter , which guarantee the existence of an optimal solution.
It is important to position our multi-period model within the context of dynamic risk measures. Extending the multi-period framework of Yu et al. [10], our model employs an additive-in-time deviation function and is therefore not time-consistent, unlike dynamic coherent risk measures (see Feinstein and Rudloff [13] and Valladao et al. [14]). This represents a conceptual limitation. However, our model maintains a simpler structure that is highly analytically tractable, enabling the derivation of closed-form solutions.
The rest of this paper is organized as follows. Section 2 introduces a multi-period investment problem with n risky assets, formulating it as a bi-objective optimization problem and defining the risk function and deviation measures for the analysis. Section 3 derives an analytical solution to the bi-objective optimization problem by applying dynamic programming, yielding a closed-form expression for the optimal investment strategy. Section 4 concludes this paper.
For a random variable X, we denote by the mathematical expectation of X throughout the paper. The space is the set of all random variables defined on the probability space for which the second moment is finite, i.e.,
In particular, the space contains all constant random variables, . The letter will always stand for a constant in the real numbers , and any (in)equalities between random variables are to be viewed in the sense of holding almost surely. We adopt the notion that
and
2. Notation and Problem Formulation
This paper examines a multi-period investment problem in a market with n risky assets. An investor begins with an initial wealth at time . The investor is then permitted to revise his/her investment decisions at the beginning of each subsequent period for a total of revisions, achieving a terminal wealth at the end of the N-th period.
At the beginning of each period, the n risky assets are sorted by ascending expected return rates. Let denote the asset with index j at time t. For this asset, we denote by the investment allocated at the beginning of period t, and by its random return rate over that period. For notational convenience, we define the following vectors:
as well as and .
Assumption 1.
The expected return rates are strictly ordered, i.e., for all .
Remark 1.
Following Meng et al. [7], Assumption 1 is necessary to define the trading strategy of shorting lower-return assets to fund higher-return ones. The model is robust to estimation errors, provided they do not alter the underlying ranking of the assets.
Let be the total wealth at the end of period t, then
Because no money is added to or withdrawn from the market during any period. The self-financing condition is satisfied, i.e.,
To ensure the problem’s feasibility and avoid bankruptcy, we impose the condition that the investor’s wealth is strictly positive at all times. Formally, we require
The risk function in period t for portfolio is given by
It is the general risk function introduced in Meng et al. [7], and is the general deviation measure of random variable X in the sense of [6]:
Definition 1.
A deviation measure is a function that satisfies
- (D1)
- for all X and constants C,
- (D2)
- and for all X and ,
- (D3)
- for all X and ,
- (D4)
- for all X, with for nonconstant X.
Due to the axiom (D2) of , we have
The following deviation measures are selected for their applicability to our model and their prevalence in existing academic literature.
- (a)
- The standard deviation ;
- (b)
- The absolute deviation ;
- (c)
- The lower semi-absolute deviation .
The deviation measures in (a)–(c) are symmetric with respect to positive and negative returns, satisfying for all j.
Remark 2.
Let , then the Equation (3) can be rewritten as
By preserving a linear framework, this risk function enables the efficient solving of portfolio optimization models. Moreover, due to axiom (D3) of , we have
This indicates that when is small, will also be relatively small.
It is instructive to compare our proposed risk measure with established benchmarks like variance and Conditional Value at Risk (CVaR). Variance requires a quadratic framework and a full covariance matrix, which is computationally prohibitive for large portfolios. CVaR, while coherent, is computationally intensive and typically lacks a closed-form solution. In contrast, preserves a linear structure that, as noted in Remark 2, is key to efficient solving and a closed-form solution. It must be acknowledged that our risk measure does not account for inter-asset correlations. However, this simplification is what makes our method particularly suitable for large-scale problems where the computation of a full covariance matrix or CVaR is prohibitively expensive.
The total risk incurred by the investor at the end of period t, denoted by for , evolves recursively according to
subject to the initial condition . The problem of a risk-averse investor, who aims to maximize expected return while minimizing risk, is naturally formulated as a bi-objective optimization problem as follows:
or equivalently
- (1)
- (2)
3. Analytic Solution
In this section, an analytical solution to problem (7) is derived using the dynamic programming approach. For a given parameter , the following parametric optimization problem is considered:
where represents the investor’s risk tolerance. A higher value of corresponds to a lower tolerance for risk. Since problem (7) is a bi-objective convex program, a portfolio is efficient for it if and only if there exists a such that is also an efficient portfolio for problem (8), see [15].
Remark 4.
A practical method for calibrating is through a risk tolerance questionnaire, which maps an investor’s profile to a quantitative value. A more formal alternative is to select such that the expected risk respects a given risk budget, or to achieve a target risk-adjusted return ratio like .
Owing to its specific structure, problem (8) is amenable to dynamic programming. Through this approach, a closed-form optimal solution is obtained using backward induction. Define
and
The following notations will be used throughout this paper:
We define by
and by
Let matrix be partitioned by its columns as , where each is a column vector. Moreover, we define:
and
The following lemma is instrumental to our analysis and follows directly from the definition of and Lemma 3.1 in Meng et al. [7].
Lemma 1.
is a continuous piecewise linear convex function with
Moreover, the function is strictly decreasing on the interval , constant on , and strictly increasing on . Consequently, it attains its minimum value on the interval .
Assuming that and are known, we first consider period N. Thus,
Consequently, problem (8) can be reformulated as follows:
The optimal solution to problem (13) is provided in the following lemma. The proof is analogous to that of Theorem 3.1 in Meng et al. [7] and is therefore omitted.
Lemma 2.
- (a)
- in the case of , ;
- (b)
- in the case of for some , .
Remark 5.
The condition is necessary for the problem to be bounded. If falls below this threshold, the weight given to risk is too small, and the investor is motivated to take on extreme risk positions for higher return, leading to an unbounded linear program.
Substituting the optimal solution from Lemma 2 into the objective function yields:
where
Furthermore, let and
then
Proceeding to period , and assuming and are known, it follows that
The problem to be solved is as follows:
A detailed proof of the subsequent theorem is presented in the Appendix A.
Theorem 1.
- (1)
- If , thenis an optimal solution to problem (14).
- (2)
- If , then the problem (14) has a nonempty optimal solution set if and only if . Meanwhile, for any fixed , an optimal solution to problem (14) is given bywhere is determined as follows:
- (i)
- in the case of with , ;
- (ii)
- in the case of with for some , ;
- (iii)
- in the case of with , ;
- (iv)
- in the case of with for some , .
Substituting the optimal solution from Theorem 1 into the objective function yields:
where
and
For a general period , if we define
then,
Assuming and are known, it follows that
The problem to be solved is as follows:
This problem is solved analogously to Theorem 1, by replacing with , with , and with .
Theorem 2.
- (1)
- If , thenis an optimal solution to problem (15).
- (2)
- If , then the problem (15) has a nonempty optimal solution set if and only if . Meanwhile, for any fixed , an optimal solution to problem (15) is given bywhere is determined as follows:
- (i)
- in the case of with , ;
- (ii)
- in the case of with for some , ;
- (iii)
- in the case of with , ;
- (iv)
- in the case of with for some , .
From the analysis above, it follows that for ,
where
and
with the terminal condition . Here, the index is determined by Theorem 2.
To enhance the clarity and applicability of our method, we present a pseudo-code at the end of this section (Algorithm 1), which details the computational procedure for the optimal solution.
| Algorithm 1: Multi-Period Portfolio Optimization via Backward Induction |
|
4. Conclusions
In this paper, we addressed a multi-period investment problem by developing a flexible and dynamic framework for decision revision. We quantified risk using a dynamic function based on the minimax diversification principle and derived analytical solutions for the optimal strategy via dynamic programming. The results demonstrated that the optimal investment decisions were systematically dependent on the assets’ expected return rates and the investor’s risk tolerance. The flexibility of the model is a notable feature, as it may allow for the accommodation of diverse investor preferences by incorporating different deviation measures.
Author Contributions
Conceptualization, H.Y. and Z.L.; methodology, H.Y.; validation, H.Y.; formal analysis, H.Y.; writing—original draft preparation, H.Y.; writing—review and editing, Z.L.; supervision, Z.L.; project administration, H.Y.; funding acquisition, Z.L. All authors have read and agreed to the published version of the manuscript.
Funding
Hongyu Yang’s work was supported by the Fundamental Research Funds for the Central Universities [25CAFUC04069]. Zijian Luo’s work was supported by the Fundamental Research Funds for the Central Universities [25CAFUC04078].
Data Availability Statement
No new data were created or analyzed in this study. The reason is this paper is a purely theoretical study involving formula derivation without any data processing.
Conflicts of Interest
The authors declare that they have no conflicts of interest, financial or otherwise. Also, informed consent was obtained from all individual participants included in the study.
Appendix A
This appendix contains the proof of Theorem 1. The proof strategy leverages the fact that problem (14) is a linear program, for which the Kuhn–Tucker conditions provide necessary and sufficient optimality criteria. Consequently, the proof reduces to finding a Kuhn–Tucker point that satisfies these conditions.
Proof.
For the case of , the Lagrangian for problem (14) is defined as
The Kuhn–Tucker conditions conditions for the optimal solution of the parametric problem (14) are then given by:
Additionally, for each :
where denotes the vector of Lagrange multipliers.
Firstly, the constraints (A4) and (A7) imply that . To prove this, assume to the contrary that . From the inequalities and , it follows that and . This implies that for all , which contradicts Equation (A1).
Secondly, from Equation (A6), we have , while from Equation (A9), it follows that . Combining these two results yields:
Furthermore, from Equation (A3), we have
which is equivalent to
Combining this with Equations (A1) and (A2), we can deduce that
Therefore, substituting this result for back into Equation (A3) yields
Combining Equations (A10) and (A11), it follows that for all , and . Therefore, substituting these results into Equation (A6) yields
Finally, Equation (A1) implies the following explicit expression for :
For the case of , the Lagrangian for problem (14) is defined as
At this point, the Kuhn–Tucker conditions for the optimal solution of the parametric problem (14) are composed of Equations (A1), (A2) and (A4)–(A9), along with the following condition, which must hold for all :
We partition the index set into the following four disjoint subsets:
Also, the constraints (A4) and (A7) imply that . This leads to the conclusion that . Otherwise, assume . Equations (A4)–(A9) then imply and , which in turn gives and thus . This is a contradiction. Therefore,
Let . It follows from (A5) and (A6) that
Consequently,
Applying (A12) also yields . From this, we obtain
so it must be that .
Let . It follows from (A8) and (A9) that
Consequently,
Applying (A12) also yields . From this, we obtain
so it must be that .
Let . It follows from (A4) and (A7) that
This can be rewritten as
where . Applying (A12) also leads to .
Based on the preceding discussion, (A1) and (A2) can be rewritten as
and
respectively. Here, the constants for are chosen to satisfy (A16).
When , the three sub-indicator sets mentioned above can be rewritten as:
Then, by combining (10) and (11), there exist such that the inequality on the right-hand side of (A16) holds if and only if . Furthermore, Equation (9) allows us to rewrite (A17) as
According to Lemma 1, for , Equation (A18) has a solution if and only if . The lemma also yields the following chain of inequalities for this interval:
In case (i), the equality yields . Consequently, and . Furthermore, Equations (10), (A13), (A15) and (A16) imply that
is an optimal solution to problem (14).
In case (ii), we have
for some , and then . Consequently, and . Furthermore, Equations (10) and (A13)–(A16) imply that
is an optimal solution to problem (14).
When , the three sub-indicator sets mentioned above can be rewritten as:
Then, by combining (10) and (11), there exist such that the inequality on the right-hand side of (A16) holds if and only if . Furthermore, Equation (9) allows us to rewrite (A17) as
According to Lemma 1, for , Equation (A19) has a solution if and only if . The lemma also yields the following chain of inequalities for this interval:
In case (iii), the equality yields . Consequently, and . Furthermore, Equations (10), (A13), (A15) and (A16) imply that
is an optimal solution to problem (14).
In case (iv), we have
for some , and then . Consequently, and . Furthermore, Equations (10) and (A13)–(A16) imply that
is an optimal solution to problem (14).
This completes the proof. □
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