Dynamic Versus Static Asset Allocation: From Theory (Halfway) to Practice

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