Robust Portfolio Choice With Frictions
34 Pages Posted: 21 Jul 2022 Last revised: 10 May 2023
Date Written: April 16, 2022
Abstract
This paper studies a robust portfolio choice problem with return predictability and price impacts in continuous time. Asset returns are modeled by some stochastic factors and trades incur both transient and permanent price impacts. Assuming ambiguity aversions toward asset returns and return-predicting factors, an investor aims to maximize the accumulated local mean-variance preference on his investment returns, netting costs due to price impacts. We characterize the robust solution of the investor's portfolio choice problem in terms of the solution to a coupled Riccati differential system, and derive sufficient conditions, in terms of the model parameters only, to address the well-posedness of the coupled system. Compared with the non-robust case, the ambiguity-averse investor adopts a more conservative optimal strategy where he puts fewer weights on assets with more volatile factors. While the permanent price impact of his trades induces the investor to trade more aggressively, his aggressiveness is constrained by the magnitude of his ambiguity aversion. Finally, our simulations indicate that the investor's robust trading strategy outperforms his non-robust counterpart, with the performance measured by the Sharpe ratio of daily returns netting the execution costs.
Keywords: Finance; Robust portfolio selection; Return predictability; Transient and permanent price impacts; Coupled differential Riccati system.
JEL Classification: G11;C61;
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