Portfolio Rebalancing: A Test of the Markowitz-Van Dijk Heuristic

23 Pages Posted: 31 Mar 2007  

Mark Kritzman

Massachusetts Institute of Technology (MIT) - Sloan School of Management

Simon Myrgren

State Street Associates

Sebastien Page

State Street Associates

Date Written: March 2007

Abstract

Institutional investors usually employ mean-variance analysis to determine optimal portfolio weights. Almost immediately upon implementation, however, the portfolio's weights become sub-optimal as changes in asset prices cause the portfolio to drift away from the optimal targets. In an idealized world without transaction costs investors would rebalance continually to the optimal weights. In the presence of transaction costs investors must balance the cost of sub-optimality with the cost of restoring the optimal weights. We apply a quadratic heuristic to address the asset weight drift problem, and we compare it to a dynamic programming solution as well as to standard industry heuristics. Our tests reveal that the quadratic heuristic provides solutions that are remarkably close to the dynamic programming solutions for those cases in which dynamic programming is feasible and far superior to solutions based on standard industry heuristics. In the case of five assets, in fact, it performs better than dynamic programming due to approximations required to implement the dynamic programming algorithm. Moreover, unlike the dynamic programming solution, the quadratic heuristic is scalable to as many as several hundreds assets.

Keywords: finance, portfolio: optimal rebalancing with transaction costs

Suggested Citation

Kritzman, Mark and Myrgren, Simon and Page, Sebastien, Portfolio Rebalancing: A Test of the Markowitz-Van Dijk Heuristic (March 2007). MIT Sloan Research Paper No. 4641-07. Available at SSRN: https://ssrn.com/abstract=976072 or http://dx.doi.org/10.2139/ssrn.976072

Mark Kritzman (Contact Author)

Massachusetts Institute of Technology (MIT) - Sloan School of Management ( email )

100 Main Street
E62-416
Cambridge, MA 02142
United States

Simon Myrgren

State Street Associates ( email )

138 Mount Auburn Street
Cambridge, MA 02138
United States

Sebastien Page

State Street Associates ( email )

138 Mount Auburn Street
Cambridge, MA 02138
United States
617-234-9462 (Phone)
617-234-9478 (Fax)

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