Portfolio optimization under dynamic risk constraints: continuous vs. discrete time trading

TL;DR

This paper compares continuous and discrete-time trading in portfolio optimization under dynamic risk constraints, showing that risk reduction is effective with manageable performance loss, and that discretization impacts are significant.

Contribution

It provides a numerical analysis of the effects of dynamic risk constraints on portfolio performance in both continuous and discrete trading settings.

Findings

Risk constraints reduce portfolio performance slightly.

Performance loss from risk constraints is less than that from infrequent trading.

Discrete trading introduces additional performance loss compared to continuous trading.

Abstract

We consider an investor facing a classical portfolio problem of optimal investment in a log-Brownian stock and a fixed-interest bond, but constrained to choose portfolio and consumption strategies that reduce a dynamic shortfall risk measure. For continuous- and discrete-time financial markets we investigate the loss in expected utility of intermediate consumption and terminal wealth caused by imposing a dynamic risk constraint. We derive the dynamic programming equations for the resulting stochastic optimal control problems and solve them numerically. Our numerical results indicate that the loss of portfolio performance is not too large while the risk is notably reduced. We then investigate time discretization effects and find that the loss of portfolio performance resulting from imposing a risk constraint is typically bigger than the loss resulting from infrequent trading.