Optimal Portfolio Strategy to Control Maximum Drawdown - The Case of Risk Based Dynamic Asset Allocation

35 Pages Posted: 7 May 2012

See all articles by Z. George Yang

Z. George Yang

Flexible Plan Investments, Ltd.

Liang Zhong

University of Delaware

Date Written: February 25, 2012


Draw-down losses from a previously reached maximum portfolio wealth level, is an important risk measure for investment management. In this study, we present a discrete trading strategy to directly control a portfolio’s maximum percentage of drawdown within a target level while maximizing the portfolio’s long term growth rate.

Modifying the continuously rebalancing models proposed by Grossman and Zhou (1993) and Cvitanic and Karatzas (1995), we define the loss control target as a Rolling Economic Drawdown (REDD) with a constant look-back window progressing in time. Additionally, investor’s risk aversion in the power law wealth utility function is specified as complement of the maximum loss limit to construct a portfolio’s risk-return efficient frontier.

We test the dynamic strategy using data of three broad asset class indexes: S&P 500 Total Return Index (SPTR), Barclays Capital 20 Year US Treasury Bond Index (TLT) and Dow-Jones UBS Commodity Total Return Index (DJUBS), with 3-month U.S. Treasury Bill as the risk-free asset. Over a test period of the past 20 years (1992-2011), a simplified risk-based out-of-sample dynamic asset allocation portfolio is robust against variations in capital market expectation inputs, and out-performs the in-the-sample calibrated model portfolio and traditional asset allocation portfolios significantly.

Keywords: portfolio optimization, risk control, drawdown loss, dynamic asset allocation, discrete trading, efficient frontier, rolling economic drawdown, leverage, risk aversion, power utility function, capital market expectation, Sharpe ratio, volatility, out-of-sample test

JEL Classification: C51, C61

Suggested Citation

Yang, Zhaoji George and Zhong, Liang, Optimal Portfolio Strategy to Control Maximum Drawdown - The Case of Risk Based Dynamic Asset Allocation (February 25, 2012). Available at SSRN: https://ssrn.com/abstract=2053854 or http://dx.doi.org/10.2139/ssrn.2053854

Zhaoji George Yang (Contact Author)

Flexible Plan Investments, Ltd. ( email )

3883 Telegraph Rd., Suite 100
Bloomfield Hills, MI 48302
United States

Liang Zhong

University of Delaware ( email )

Newark, DE 19711
United States
3023575709 (Phone)

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