Effects of correlations and fees in random multiplicative environments: Implications for portfolio management

Effects of correlations and fees in random multiplicative environments: Implications for... Geometric Brownian motion (GBM) is frequently used to model price dynamics of financial assets, and a weighted average of multiple GBMs is commonly used to model a financial portfolio. Diversified portfolios can lead to an increased exponential growth compared to a single asset by effectively reducing the effective noise. The sum of GBM processes is no longer a log-normal process and has a complex statistical properties. The nonergodicity of the weighted average process results in constant degradation of the exponential growth from the ensemble average toward the time average. One way to stay closer to the ensemble average is to maintain a balanced portfolio: keep the relative weights of the different assets constant over time. To keep these proportions constant, whenever assets values change, it is necessary to rebalance their relative weights, exposing this strategy to fees (transaction costs). Two strategies that were suggested in the past for cases that involve fees are rebalance the portfolio periodically and rebalance it in a partial way. In this paper, we study these two strategies in the presence of correlations and fees. We show that using periodic and partial rebalance strategies, it is possible to maintain a steady exponential growth while minimizing the losses due to fees. We also demonstrate how these redistribution strategies perform in a phenomenal way on real-world market data, despite the fact that not all assumptions of the model hold in these real-world systems. Our results have important implications for stochastic dynamics in general and to portfolio management in particular, as we show that there is a superior alternative to the common buy-and-hold strategy, even in the presence of correlations and fees. http://www.deepdyve.com/assets/images/DeepDyve-Logo-lg.png Physical Review E American Physical Society (APS)

Effects of correlations and fees in random multiplicative environments: Implications for portfolio management

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Effects of correlations and fees in random multiplicative environments: Implications for portfolio management

Abstract

Geometric Brownian motion (GBM) is frequently used to model price dynamics of financial assets, and a weighted average of multiple GBMs is commonly used to model a financial portfolio. Diversified portfolios can lead to an increased exponential growth compared to a single asset by effectively reducing the effective noise. The sum of GBM processes is no longer a log-normal process and has a complex statistical properties. The nonergodicity of the weighted average process results in constant degradation of the exponential growth from the ensemble average toward the time average. One way to stay closer to the ensemble average is to maintain a balanced portfolio: keep the relative weights of the different assets constant over time. To keep these proportions constant, whenever assets values change, it is necessary to rebalance their relative weights, exposing this strategy to fees (transaction costs). Two strategies that were suggested in the past for cases that involve fees are rebalance the portfolio periodically and rebalance it in a partial way. In this paper, we study these two strategies in the presence of correlations and fees. We show that using periodic and partial rebalance strategies, it is possible to maintain a steady exponential growth while minimizing the losses due to fees. We also demonstrate how these redistribution strategies perform in a phenomenal way on real-world market data, despite the fact that not all assumptions of the model hold in these real-world systems. Our results have important implications for stochastic dynamics in general and to portfolio management in particular, as we show that there is a superior alternative to the common buy-and-hold strategy, even in the presence of correlations and fees.
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Publisher
The American Physical Society
Copyright
Copyright © ©2017 American Physical Society
ISSN
1539-3755
eISSN
550-2376
D.O.I.
10.1103/PhysRevE.96.022305
Publisher site
See Article on Publisher Site

Abstract

Geometric Brownian motion (GBM) is frequently used to model price dynamics of financial assets, and a weighted average of multiple GBMs is commonly used to model a financial portfolio. Diversified portfolios can lead to an increased exponential growth compared to a single asset by effectively reducing the effective noise. The sum of GBM processes is no longer a log-normal process and has a complex statistical properties. The nonergodicity of the weighted average process results in constant degradation of the exponential growth from the ensemble average toward the time average. One way to stay closer to the ensemble average is to maintain a balanced portfolio: keep the relative weights of the different assets constant over time. To keep these proportions constant, whenever assets values change, it is necessary to rebalance their relative weights, exposing this strategy to fees (transaction costs). Two strategies that were suggested in the past for cases that involve fees are rebalance the portfolio periodically and rebalance it in a partial way. In this paper, we study these two strategies in the presence of correlations and fees. We show that using periodic and partial rebalance strategies, it is possible to maintain a steady exponential growth while minimizing the losses due to fees. We also demonstrate how these redistribution strategies perform in a phenomenal way on real-world market data, despite the fact that not all assumptions of the model hold in these real-world systems. Our results have important implications for stochastic dynamics in general and to portfolio management in particular, as we show that there is a superior alternative to the common buy-and-hold strategy, even in the presence of correlations and fees.

Journal

Physical Review EAmerican Physical Society (APS)

Published: Aug 7, 2017

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