Dynamic versus Static Asset Allocation: From Theory (halfway) to Practice

Didier Maillard1

March 2011

1 Professor, Chair of Banking, Conservatoire national des arts et métiers (Cnam), 40 rue des Jeûneurs, Paris
75002, didier.maillard@cnam.fr

Electronic copy available at: http://ssrn.com/abstract=1942901

Abstract

In a static optimisation process, the structure of the portfolio in which the investor’s wealth is
invested is chosen once for all at the beginning of the period. In a dynamic optimisation
process, the structure of the portfolio is continuously (at least theoretically) adjusted. There is
no doubt that the dynamic optimisation process is superior to the static one, as one of the
dynamic strategies among many is to choose not to adjust the portfolio structure, i.e. to
choose a static strategy.

The aim of this paper is to assess, with parameter values as reasonable as possible, the order
of magnitude of the extent by which the dynamic optimisation process dominates the static
optimisation process; and to gauge whether the existence of transaction costs changes
significantly the assessment.

That assessment is made considering that the values of the relevant parameters are known at
the beginning of the investment period. The paper thus does not to try to assess the benefits
that dynamic optimisation could reap by incorporating new information on those parameters.

The main results are that for high risk adverse investors, the improvement provided by
dynamic versus static optimisation is moderate; it may be huge for low risk adverse investors,
but this comes principally from the fact that dynamic optimisation leads to a huge leverage,
which is normally prohibited in a static framework. Reasonable values for transaction costs do
not jeopardise the superiority of dynamic asset allocation.

Keywords: Asset allocation, Portfolio management, Portfolio Optimization.

JEL classification: G11

Electronic copy available at: http://ssrn.com/abstract=1942901

1 – Introduction

Asset allocation and more generally portfolio optimisation may be considered in a static
framework or in a dynamic framework.

In a static optimisation process, the structure of the portfolio in which the investor’s wealth is
invested is chosen once for all at the beginning of the period. In a dynamic optimisation
process, the structure of the portfolio is continuously (at least theoretically) adjusted. There is
no doubt that the dynamic optimisation process is superior to the static one, as one of the
dynamic strategies among many is to choose not to adjust the portfolio structure, i.e. to
choose a static strategy.

The aim of this paper is to assess, with parameter values as reasonable as possible, the order
of magnitude of the extent by which the dynamic optimisation process dominates the static
optimisation process; and to gauge whether the existence of transaction costs changes
significantly the assessment.

That assessment is made considering that the values of the relevant parameters are known at
the beginning of the investment period. The paper thus does not to try to assess the benefits
that dynamic optimisation could reap by incorporating new information on those parameters.

The main results are that for high risk adverse investors, the improvement provided by
dynamic versus static optimisation is moderate; it may be huge for low risk adverse investors,
but this comes principally from the fact that dynamic optimisation leads to important short
positions, which are normally prohibited in a static framework. Reasonable values for
transaction costs do not jeopardise the superiority of dynamic asset allocation.

2 –Static and dynamic asset allocation

The static portfolio optimisation problem is stated in the following terms: given an investor
with a set of preference, and particularly an attitude towards risk (described by a utility
function U), and a precise time horizon T, which portfolio, whose structure is chosen once for
all at the beginning of the period, maximises its expected utility?

3
MaxE[U (W (T ))]
W (T ) = W (0)∑ xi (1 + Ri ,T )
i

W(0) is wealth at time 0, when the allocation decision is made. W(T) is final wealth, which
provides utility U (In fact, utility is derived from the consumption made possible in the future
by the purchasing power of final wealth). E(U) is the expected utility, which the investor tries
to optimise, along the von Neumann-Morgenstern framework.

xi is the share of initial wealth invested in asset i, at time 0. Ri,T is the –random- return on asset
i over the period (from time 0 to time T). There may or there may not exist a risk-free asset. In
case there is a risk-free asset, it will be assigned index 0. Risky assets will be numbered from
1 to n. x is the vector of the risky assets shares in the initial portfolio.

Except for a quadratic utility function (whose properties make it unfit to describe actual
situations), there is no easy analytical solution to the above maximisation problem and the
assets weights in the allocation have to be computed numerically.

The dynamic portfolio optimisation problem allows the share of asset i in wealth to vary
continuously from time 0 to time T: the portfolio is continuously rebalanced.

The optimisation problem becomes:

MaxE[U (W (T ))]
dW (t )
= x0 (t )r (t )dt + x' (t )d R(t ) = r (t )dt + ( x' (t ) − r (t )1' )d R(t )
W (t )
d R(t ) = µ (t )dt + Σ(t )d w Σ' (t )Σ(t ) = V (t )

1 is a vector of ones, the size of the number of risky assets, ‘ corresponds to the transpose of a
vector or matrix. dw is a standard n-dimensional Brownian process, dR the vector of
instantaneous returns on the risky assets, sums of a drift and a random component generated
by the Brownian and a variance-covariance matrix V.

4
Using rather sophisticated tools such as Cox-Huang and Karatzas, it may be shown that this
optimisation has analytical solutions, in the case of a logarithmic utility function and also in
case of a CRRA1 utility function.

If the utility function is logarithmic:

U (W ) = ln W

The (continuous varying) optimal portfolio is composed of a share α(t) of a portfolio uniquely
composed of risky assets s and a share 1- α(t) of the risk-free asset.

V −1 (t )( µ (t ) − r (t )1)
s (t ) =
1' V −1 (t )( µ (t ) − r (t )1)

That portfolio’s structure is formally identical to the solution of a static optimisation (at a
t + dt horizon) with a risk-free asset in a mean-variance framework and corresponds to the
maximum Sharpe ratio. We will call portfolio s the instantaneous Sharpe Ratio (SR)
maximising portfolio.

The share of the optimal portfolio which in invested in s equals:

µ s (t ) − r (t )
α (t ) = 1' V −1 (t )( µ (t ) − r (t )1) =
σ s2

If the utility function is CRRA:

W 1−γ
U (W ) =
1− γ

1
CRRA stands for Constant Relative Risk Aversion. Risk aversion is minus the ratio of the second to the first
derivative of the utility function. Relative Risk Aversion is Risk Aversion divided by the argument of the utility
function.

5
and if the parameters are constant throughout time, the (continuous varying) optimal portfolio
is composed of a share αγ of the same portfolio uniquely composed of risky assets s and a
share 1- αγ of the risk-free asset, with:

α µs − r
αγ = =
γ γσ s2

Final wealth will be given by (see Appendix I):

( r +α γ ( µ s − r ) −α γ2σ 2 / 2 )T αγ σ s T ε
W (T ) = W (0)e e

where ε is a normal standard random variable.

With a relative risk aversion equal to 1,

U (W ) = ln W
ln W (T ) = ln W (0) + (r + α ( µ s − r ) − α 2σ s2 / 2)T + α γ σ s T ε
E (ln(W (T )) = ln W (0) + (r + α ( µ s − r ) − α 2σ s2 / 2)T as E (ε ) = 0

With a RRA equal to γ (see Appendix I),

U (W ) = (1 − γ ) −1W 1−γ
(1−γ )( r +α γ ( µ s − r ) −γα γ2σ s2 / 2 )T
E (U (W (T ))) = (1 − γ ) −1W (0)1−γ e

Computing it directly, or using above expression with γ = 0:

( r +α γ ( µ s − r ))T
E (W (T )) = W (0)e

It is also possible to compute the volatility of final wealth (see Appendix I), which leads to:

α γ2σ s2T
σ (W (T )) = E (W (T )) e −1

6
Using CRRA utility functions to represent the investor’s preferences entails a certain loss of
generality. A more general class of utility functions may be found in the HARA utility
functions, which are formally identical to CRRA utility functions except for the fact that the
argument is not actual consumption but actual consumption less a fixed term corresponding to
a consumption threshold: utility is generated only when actual consumption is in excess of
that threshold, representing first necessity goods.

(W − Wˆ )1−γ
U (W ) =
1− γ

However, it may be shown that for those utility functions, the optimal portfolio in a dynamic
optimisation process consists of an investment in the risk-free asset, fixed at the beginning of
the period, and whose amount corresponds to what is necessary to reach the consumption
threshold, the rest being invested in a dynamically managed portfolio whose characteristics
are the same as in the case of the CRRA utility function. The nature of the comparison
between static and dynamic optimisation is thus unchanged by choosing this more general
class of utility functions.

3 – Numerical computations

3.1 – Parameters and first computations

We start with the (rather strong) assumption that the return on the risk-free asset is non-
stochastic and constant, as well as the mean return on the risky assets, as well as the variance-
covariance matrix.

We consider two risky assets, that we call equity and bond2. We consider there is no
correlation between the assets returns. This assumption is not as strong as it may appear as
one can, in case of correlation, substitute two uncorrelated portfolios, built with the two
assets, for the two assets considered.

2
What is labelled “Bond” will rather be a bond fund with duration maintained constant throughout time.

7
We retain for the risk-free return, the drifts and volatilities the following values (defined in
annual terms).

Exp. return. Volatility

Risk-free 2%
Equity 10% 20%
Bond 4% 6%

Correlation 0

The variance-covariance matrix is easily computed:

V Equity Bond
Equity 0.04 0
Bond 0 0.0036

then inversed:

V-1 Equity Bond

Equity 25 0
Bond 0 277.778

Portfolio s, which is composed of risky assets and maximises the instantaneous Sharpe Ratio,
may be computed, by multiplying matrix V-1 by the vector of excess expected returns
(expected return above risk-free return), and normalising so that the sum of the asset shares
equals 1:

V-1 Equity Bond Excess exp ret. Matricial prod. s

Equity 25 0 8% 2.000 0.265
Bond 0 277.778 2% 5.556 0.735
7.556 1.000

This instantaneously optimal risky portfolio is composed of a little more than a quarter equity
and a little less than three quarters bond.

3.2 – Dynamic optimisation

8
Simulations will be processed with four values for the relative risk aversion parameter: 1
(which corresponds to a log utility function), 5 10, and 15. This covers a range usually
considered as relevant for the description of actual behaviours (2 to 10).

The results of the dynamic optimisation process are as following.

Dynamic optimisation

γ 1 5 10 15
αγ 7,5556 1,5111 0,7556 0,5037
E(U(W(T)) 1,555556 -0,037978 -0,005422 -0,001226
E(W(T)) 18,3772 2,1006 1,6018 1,4634
σ(W(T)) 68,8740 0,7109 0,2655 0,1611

As expected, the share invested in risky assets declines with relative risk aversion. However,
for low risk aversion values, the theoretically optimal solution consists of an aggressively
huge long position in risky assets with a huge short position in the risk-free asset.

Such a short position in the risk-free asset is sustainable if the portfolio is continuously
rebalanced. Otherwise, there is the risk that with such a structure wealth may become
negative, with a non-zero probability: the whole process of optimisation is jeopardized.

To assess the usefulness of the dynamic optimisation process, we may compare the outcome
of the optimal portfolio choice with non optimal investments, such as an investment purely in
the risk-free asset, or in equity, or in bond, or in the instantaneously optimal risky portfolio
(i.e. constraining α to be equal to 1).

Such investments will lead to inferior values for the expected utility function. It is however
uneasy to compare directly utility function outcomes. We will therefore use the same method
as the one used in traditional general-equilibrium microeconomics to “monetise” welfare
losses.

The measure of welfare loss WL we will use precisely is the extent of the relative additional
initial wealth which is needed, with a non optimal investment, to reach the same level of

9
expected utility as in the case of the optimal investment. It is expressed as a share of initial
wealth.

W ' (0) − W (0)

WL =
W (0)

With a RRA equal to 1, W’(0) will be such that:

E (ln(W (T ))) = ln(W (0)) + X

E (ln(W (T )))* = ln(W (0)) + X * = ln(W ' (0)) + X
W ' (0) = W (0)e X *− X = W (0)e E (ln(W (T )))*− E (ln(W (T )))

where * refers to the dynamically optimal situation.

With a RRA equal to γ other than 1, W’(0) will be such that:

E (U (W (T )) = W (0)1−γ X
E (U (W (T ))* = W (0)1−γ X * = W ' (0)1−γ X
1 1
 X *  1−γ  E (U (W (T )) *  1−γ
W ' (0) = W (0)  = W (0) 
 X   E (U (W (T )) 

10
 • Comparison with an investment in the risk-free asset

Investment in the risk-free asset

γ 1 5 10 15
E(U(W(T)) 0.200000 -0.112332 -0.018367 -0.004344
E(W(T)) 1.2214 1.2214 1.2214 1.2214
σ(W(T)) 0 0 0 0
WL 287.89% 31.14% 14.52% 9.46%

As expected, avoiding risky assets is particularly costly for low risk aversions, and moderately
for high risk aversions.

• Comparison with an investment in equity

Investment in equity

γ 1 5 10 15
E(U(W(T)) 0.800000 -0.250000 -900.342659 -1.03304E+11
E(W(T)) 2.7183 2.7183 2.7183 2.7183
σ(W(T)) 1.9063 1.9063 1.9063 1.9063
WL 112.88% 60.18% 280.21% 887.86%

An investment purely in equity is costly, compared to the optimal investment. For high risk
aversions, it is because of the price of risk. For low risk aversions, it is because the
opportunity of shorting the risk-free asset is missed.

• Comparison with an investment in bond

Investment in bond

γ 1 5 10 15
E(U(W(T)) 0.382000 -0.072346 -0.015341 -0.011573
E(W(T)) 1.4918 1.4918 1.4918 1.4918
σ(W(T)) 0.2856 0.2856 0.2856 0.2856
WL 223.35% 17.48% 12.25% 17.39%

11
An investment in bond compares less unfavourably with the optimal investment than an
investment in equity, except for low risk aversion.

• Comparison with an investment in the maximum instantaneous SR portfolio

This corresponds to constraining α to 1.

Investment in s

γ 1 5 10 15
E(U(W(T)) 0.535078 -0.042995 -0.006161 -0.004186
E(W(T)) 1.7486 1.7486 1.7486 1.7486
σ(W(T)) 0.3856 0.3856 0.3856 0.3856
WL 177.45% 3.15% 1.43% 9.17%

3.3 – Static optimisation

The chosen time span is ten years (T = 10). Over that period, the cumulative returns on the
various assets are:

R0,T = e rT − 1 for the risk-free asset

Ri ,T = e ( µi −σ i / 2 ) T +σ i T ε i
− 1 for risky asset i, where εi is a standard normal random variable.
2

To assess the outcome of nearly dynamic optimisation, and for all further simulations, we use
a set of 2,000 standard normal random variable draws εij with:
- i the risky asset (i = equity, bond)
- j the particular outcome (j = 1,…,1000)

Furthermore, to ensure that the random variables are perfectly centred, we add to the sample
the opposite of any random variable outcome, leading to 4,000 outcomes:

εi,j+1000 = -εtj

12
Finally, as we wish to compare simulation results (for the static case) to numerical results (the
dynamic optimisation case, which will be used as a baseline), we replace the values of the
draw by those values divided by the empirical standard-error, in order to obtain zero empirical
mean and one empirical standard error random variables.

The optimal static portfolio is then computed by iterations, according to the level of risk
aversion.

Static optimisation

γ 1 5 10 15
E(U(W(T)) 0.800000 -0.042668 -0.005756 -0.001314
E(W(T)) 2.7176 1.9221 1.6528 1.5071
σ(W(T)) 1.9031 0.6898 0.3909 0.2580
WL 112.88% 2.95% 0.67% 0.50%
Risk-free 0.000 0 0.266 0.510
Equity 1.000 0.351 0.190 0.125
Bond 0.000 0.649 0.544 0.365

Let’s comment those results starting from the cases with high risk aversion (γ = 10 or 15).

The optimal static portfolio tends to have a little more risk-free asset weight than the dynamic
optimal portfolio (0.266 versus 0.244 and 0.510 versus 0.496), but the differences are not
huge. The equity share in the risky part of the portfolio tends to be similar (25.8 % for a risk
aversion equal to 15 and 25.5 % for a risk aversion equal to 15 versus for 26.5 % in the
dynamic case).

There is a welfare loss not to continuously adjust the portfolio structure but it is quite mild,
less than one per cent.

For an intermediate risk aversion parameter of 5, the welfare loss becomes significant. This is
mainly due to the fact that static optimisation requires not to take short positions (in the
dynamic optimisation, there is a short of -0.5556 in the risk-free asset).

To compensate partially for this impossibility to take risk by shorting the risk-free asset, the
relative share of equity compared to bond increases.

13
These features are magnified for a low risk aversion of 1, where the welfare loss is in excess
of one hundred per cent. This comes nearly entirely from the inability to short the risk-free
asset (-6.556 in the dynamic optimisation process). As a result, the optimal portfolio is
entirely composed of the most risky asset, i.e. equity.

It is worth noting that except for low risk aversion, the outcome of the static optimisation
process is much better than the outcome of investments in pure assets (risk-free, bond or
equity), as the comparison of welfares losses shows: asset allocation, or at least
diversification, adds value.

3.4 – Nearly dynamic optimisation

Purely dynamic optimisation does not exist in practice, as it would require a continuous
stream of transactions on financial markets: actual transactions occur at discrete times, for a
quantum of assets, and are not possible during periods of time.

As a way of approaching dynamic optimisation we will divide the time span (10 years) into
sub periods, during which the portfolio will not be rebalanced. As a compromise between the
needed computing power and the closeness of the approximation, we will retain ten sub
periods covering one year each.

Over a one-year period, the return on the risk-free asset is:

R0 = e r − 1 for the risk-free asset

Ri = e µi −σ i / 2 +σ i ε i
− 1 for risky asset i, where εi is a standard normal random variable.
2

To assess the outcome of nearly dynamic optimisation, and for all further simulations, we use
a set of 40,000 standard normal random variable draws εitj with:
- i the risky asset (i = equity, bond)
- t the year (t = 1,…,10)
- j the particular outcome (j = 1,…,1000)

14
Furthermore, to ensure that the random variables are perfectly centred, we add to the sample
the opposite of any random variable outcome, leading to 40,000 outcomes:

εit,j+1000 = -εitj

We then implement the optimal dynamic strategy, except that we do not accept short
positions, which lead for low relative aversions to constrain the position in the risk-free asset
to be zero and the portfolio to have the structure of s.

The results are following:

Nearly dynamic optimisation

γ 1 5 10 15
E(U(W(T)) 0.537527 -0.043594 -0.005749 -0.001309
E(W(T)) 1.7557 1.7557 1.6085 1.4686
σ(W(T)) 0.4020 0.4020 0.2792 0.1708
WL 176.77% 3.51% 0.65% 0.47%

There is a welfare loss using annual rebalancing compared to continuous rebalancing, small
for high risk aversions and high for low risk aversions, because of the limit on risk taking.

For low risk aversions, the outcome of nearly dynamic optimisation could be improved by
increasing the share of equity as a way of –inefficiently- taking more risk.

It is interesting finally to compare the outcome of dynamic, nearly dynamic and static
optimisation. However, due to some pitfalls in the numerical computations (see appendix II),
it is more appropriate to use for the comparison the assessment made for static optimisation
on a set of random variables compatible with the one used for nearly dynamic optimisations.

Static optimisation (corrected)

15
 γ 1 5 10 15
E(U(W(T)) 0.800000 -0.043676 -0.005953 -0.001359
E(W(T)) 2.7365 1.8982 1.6273 1.4898
σ(W(T)) 1.9388 0.6649 0.3655 0.2409
WL 112.88% 3.56% 1.04% 0.74%
Risk-free 0.000 0 0.275 0.517
Equity 1.000 0.327 0.169 0.111
Bond 0.000 0.673 0.556 0.372

The comparison makes sense for high risk aversion parameters.

3.5 – The impact of transaction costs

At the end of a period (one year in the current simulations), the portfolio structure is
transformed from xi to x’i.

xi (1 + Ri )
x'i = n

∑x
j =0
j (1 + R j )

To rebalance the portfolio, a sell or a buy of asset i will be needed, for an amount equal to the
value of the portfolio at the beginning of the year multiplied by:

x 'i − xi

The transaction will generate costs. We assume for the sake of simplicity that the cost is
proportionate to the transaction value, that it is the same for a buy or a sell (which is generally
true in practice) and that the rate τ is the same for all assets (in practice transaction costs
increase generally moderately with the risk of the asset), transactions costs will be equal to the
initial value of the portfolio times:

n
τ ∑ x ' i − xi
i =0

16
That means that during the period, the return on the portfolio will be reduced from RP to R’P,
such that:

n
1 + R ' P = (1 + R ' P )(1 − τ ∑ x' i − xi )
i =0

We replace in the simulations the annual rates of return by the annual rates of return after
transactions costs for the nine years (for the tenth and last year, transactions costs may be
incurred if the portfolio is sold to be consumed for example, but that will happen whatever the
allocation strategy, so we don’t take them into account in the comparisons). We use a
reasonable rate of 0.5% for the transaction costs.

We obtain the following results:

Nearly dynamic optimisation with transaction costs

γ 10 15
E(U(W(T)) -0.005881 -0.001346
E(W(T)) 1.6040 1.4653
σ(W(T)) 0.2780 0.1701
WL 0.91% 0.67%

In the case of a RRA of 10, welfare loss increases from 0.65 % (nearly dynamic optimisation)
to 0.91 %, i.e. by 0.26 %.

This result may be obtained approximately by noting that average rebalancing needed to
maintain the portfolio structure constant (with 0.2444 risk-free, 0.20 equity and 0.5556 bond)
represents 6.1 % of the portfolio value. This leads to an average yearly return loss of 6.1 %
times 0.5 %, i.e. 0.0305 %, and an average loss of return over the period approximately equal
to nine times 0.0305 %, i.e. 0.274 %.

As the expected utility function is proportionate to the utility of the expected final value of the
portfolio (see Appendix I), and as the risk resulting from the transactions (the rebalanced that
is needed is random) is quite small compared to the risk resulting from the risky assets, the
loss of return translates approximately into an equivalent amount of welfare loss.

17
For a RRA of 15, the average needed rebalancing represents 5 %, the impact on yearly returns
0.025 %, and the impact on the whole period 0.225 %. The additional welfare loss reaches
0.20 % (from 0.47 % to 0.67 %).

According to those computations, the outcome of nearly dynamic optimisation remains

slightly better than the outcome of static optimisation, but not much better. What would
appear if we used more frequent rebalancing in nearly dynamic optimisation?

A partial answer may be found in looking at the empirical transaction costs. Rebalancing is
needed because on the one hand the drifts in returns vary from one asset to another. It is
needed on the other hand because of the random fluctuations in the asset returns (except for
the risk-free asset). The magnitude of the first phenomenon is proportionate to the length of
the period of time at which rebalancing occurs; the magnitude of the second is proportionate
to the square root of that length.

For the first cause of rebalancing, the impact on return will thus be independent of the
periodicity of rebalancing; for the second cause it will increase as the period shorten. Using
our set of simulations, we can gauge the relative importance of those two contributions.

For a RRA of 10, the average needed rebalancing is, as seen before, 6.1 % for a yearly period.
If the period was one sixteenth of a year, the average needed rebalancing would reach 1.65 %,
which is close to 6.1 %/4 = 1.55 %.

If the period was a year divided by 256, i.e. a trading day, the average needed rebalancing
would reach 0.79 %.

The impact of transaction costs thus tends to increase significantly with the frequency at
which the portfolio is rebalanced. A more frequent rebalancing than a yearly one would thus
not be likely to improve the outcome.

4 – Conclusions

18
We have compared in this paper the outcomes, in terms of expected utility, of a dynamic
optimisation strategy and a static optimisation strategy.

That comparison is processed considering that the values of the relevant parameters
(expected returns and volatilities) are known at the beginning of the investment period. The
paper thus does not to try to assess the benefits that dynamic optimisation could reap by
incorporating new information on those parameters, if there is one indeed.

For reasonable risk aversion parameters, that do not lead to take short positions in assets
classes (particularly in the risk-free asset), the outcome of a dynamic optimisation strategy is
better, but only slightly better, than the outcome of a static optimisation strategy. However,
the outcomes of those optimal strategies are much better than the outcomes of non optimal
investments, and particularly of non diversified investments.

Dynamic optimisation is not implementable in practice, which leads to consider nearly

dynamic optimisation, where portfolio rebalancing occurs periodically.

For a one-year periodicity, nearly dynamic optimisation is not as good as theoretical dynamic
optimisation, and remains slightly better than static optimisations, though by not much when
transaction costs are taken into account with reasonable values. It is likely that more frequent
rebalancing would deteriorate the outcome, taking into account transaction costs.

19
 References

Bajeux-Besnainou, I., Jordan , J.V., Portait, R., “Dynamic Asset Allocation for Stocks, Bonds
and Cash”, Journal of Business April 2003, Vol. 76, No. 2

Karatzas, I., J. Lehoczky, and S. Shreve. 1987. Optimal portfolio and consumption
decisions for a "small investor" on a finite horizon. SIAM Journal on Control and
Optimization, 25: 1157-1186.

Martellini, L., Milhau, V., Measuring the Benefits of Dynamic Asset Allocation Strategies in
the Presence of Liabilities Constraints, Edhec Risk Research Paper, March 2009

20
 Appendix I
If a share α is invested in portfolio s, with expected return µs = µ and volatility σs = σ, and 1-α
in the risk-free asset returning r, the change in wealth over time follows the following
equation:

= (1 − α )rdt + α ( µdt + σdz ) = [r + α ( µ − r )]dt + ασdz

dW
W

where dz is a standard brownian

Ito’s lemma gives:

 1 
d ln W = r + α ( µ − r ) − α 2σ 2  dt + ασdz
 2 

T
W (T )  1 
∫ d ln W = ln W (T ) − ln W (0) = ln W (0) = r + α ( µ − r ) − 2 α σ 2 T + ασ T ε
2

0 

where ε is a normal standard random variable.

If:
 1 
U (W ) = ln W E (U (W (T ))) = ln W (0) + r + α ( µ − r ) − α 2σ 2 T + ασ T E (ε )
 2 
 1 
E (U (W (T ))) = ln W (0) + r + α ( µ − r ) − α 2σ 2 T as E (ε ) = 0
 2 
It is easy to verify that the expected utility is maximised for:

µ −r
α=
σ2

In all cases (meaning whatever the utility function and whatever the risky portfolio),

 1 2 2
 r +α ( µ − r ) − 2 α σ  T +ασ T ε
W (T ) = W (0)e  

21
  1 2 2  1 2 2 1
 r +α ( µ − r ) − 2 α σ  T  r +α ( µ − r ) − 2 α σ  T α 2σ 2T
E (W (T )) = W (0)e  
E (e ασ Tε
) = W ( 0) e  
e2 = W (0)e [r +α ( µ − r ) ]T
2
  r +α ( µ − r ) − 2 α σ  T 
 1 2 2
2 [r +α ( µ − r ) ]T
1 2 2
4α σ T

E ((W (T )) ) = W (0)e
2   
E (e 2ασ Tε
) = (W (0)) e 2
e −α 2σ 2T
e 2
 
 
a2
aε
as E (e ) = e 2
for any a
E ((W (T )) ) = ( E (W (T ))) 2 eα σ
2 2
2 T

σ 2 (W (T )) = E ((W (T )) 2 ) − ( E (W (T ))) 2 = ( E (W (T ))) 2 e α σ [ 2 2

T
−1 ]
σ (W (T )) = E (W (T )) e α σ −1
2 2
T

If:

U (W ) = (1 − γ ) −1W 1−γ
(1−γ )( r +α γ ( µ s − r ) −α γ2σ s2 / 2 )T (1−γ )α γ σ s T ε
U (W (T )) = (1 − γ ) −1W (0)1−γ e e
(1−γ )( r +α γ ( µ s − r ) −α γ2σ s2 / 2 )T (1−γ ) 2 α γ2σ s2T / 2
E (U (W (T ))) = (1 − γ ) −1W (0)1−γ e e
(1−γ )( r +α γ ( µ s − r ))T − (1−γ )α γ2σ s2 / 2 )T + (1−γ ) 2 α γ2σ s2 / 2 )T
E (U (W (T ))) = (1 − γ ) −1W (0)1−γ e
(1−γ )( r +α γ ( µ s − r ) −γα γ2σ s2 / 2 )T −γ (1−γ )α γ2σ s2T / 2
E (U (W (T ))) = (1 − γ ) −1W (0)1−γ e = U ( E (W (T )))e

γ (1−γ )
−
 σ 2 (W (T ))  2
E (U (W (T ))) = U ( E (W (T ))) 1 + 2 
 E (W (T )) 

22
 Appendix II

Numerical simulations

There are two ways of simulating cumulative returns over the 10 year period. One is to use a
set of random variables and compute the returns as:

Ri ,T = e ( µi −σ i / 2 ) T +σ i T ε i
−1
2

That gives for the equity and bond returns the following statistics, to be compared to the
theoretical expected return and expected volatility.

Draw result
Equity Bond
Average 2.7176 1.4918
Volatility 1.9031 0.2863

Theoretical
Average 2.7183 1.4918
Volatility 1.9063 0.2856

There is not much difference between the simulated and theoretical values, which is a
condition to compare theoretical results (dynamic optimisation) and simulated ones (static
optimisation).

The other way is to simulate yearly returns and cumulate them over the 10 year period.

Ri , = e ( µi −σ i / 2 ) +σ i ε i
−1
2

The simulation of yearly returns is quite good.

Equity Theoretical Average

Average 10.517% 10.515%
Volatility 22.326% 22.305%

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 Bond Theoretical Average
Average 4.081% 4.084%
Volatility 6.250% 6.293%

However, due certainly to some unwanted empirical autocorrelation; the cumulative return
empirical parameters tend to depart significantly from the theoretical ones.

Draw result
Equity Bond
Average 2.7365 1.4908
Volatility 1.9388 0.2798

Theoretical
Average 2.7183 1.4918
Volatility 1.9063 0.2856

There is no obvious quick solution to eliminate this bias.

We have thus chosen in the core of the paper to compare dynamic and static optimisation
using the first method of simulation, and to compare static and nearly dynamic optimisation
using the second set.

However, we have to acknowledge that the figures for the comparison between dynamic
optimisation and static optimisation have to be taken with a certain margin of approximation.

Several tests tend to show that the simulation results accuracy tends to be of an order of
magnitude of 0.5% when expressed equivalently to welfare losses.

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