The Optimal Portfolio Revision Policy

In a dynamic setting, portfolio management is a portfolio revision process through which an investor revises his portfolio periodically to adapt to changing conditions, either endogenous or exogenous to the portfolio. For example, an investor accepting an intrinsic-value hypothesis may find it profitable to revise his portfolio when his expectations in returns and the riskiness of some earning assets deviate significantly from those of the market. Likewise, an investor accepting the random-walk hypothesis may find it profitable to revise his portfolio because of an exogenously determined cash demand (either inflow or outflow) or changes in portfolio value and proportions due to change in prices of earning assets and cash earnings received. The problem is of considerable importance because investment decisions are usually made starting with a portfolio rather than cash, and consequently some assets must be liquidated to permit investment in others. Despite its importance, the problem has received only limited attention in the literature. This paper seeks to address this problem. After briefly reviewing single-period and multiperiod portfolio selection models, we shall examine a revision procedure proposed by Smith' and illustrate its inadequacies. In Section II, an alternative single-period portfolio revision model is formulated and compared with Smith's model. The model takes into consideration the expected transfer costs to be incurred in the transition. In Section III, the model is extended to the multiperiod case and compared with the Mossin's dynamic portfolio selection model. Section IV summarizes the findings and indicates areas for further research.