INTRODUCTION:

'Take calculated risks. This is quite different from being rash General George S Patton, 1944
In the past almost all portfolio theory used to deal with the single period portfolio problem. However, this approach was not really practical as most portfolio problems are multi-period in naturei. The financial fortunes of listed and other companies may rise and fall during economic cycles although most do not do so in unison. Consequently portfolios need to be updated on an ongoing, but not necessarily continuous basis, in order to maximise shareholder wealth. Many shareholders need to draw or consume from their portfolios during their lifetimes and it would not make good economic sense to be wedded to a non-performing security. In this thesis we deal with a class of investment models that can be said to fall midway between the single period model and continuous time portfolio theory, the latter being somewhat intractable in the real world. This discrete time multi-period type of model has the advantage of being able to handle all types of return distributions and is robust to non-stationary return distributions. Moreover, it lends itself naturally to the problem of rebalancing portfolios over many periods (Grauer and Hakansson, 1986)ii. In the case of this thesis portfolio rebalancing was carried out over a period of 120 months. Development work on the multi-period portfolio model can be said to have started almost 30 years ago with work of Mossin (1968) iii, who credits Arrow (1965) with having prepared the ground for a more general approach. In this regard it is interesting to consider the comments of Professor Robert Merton (1990). "As recently as a generation ago, finance theory was still little more than a collection of anecdotes, rules of thumb, and manipulations of accounting data. The most sophisticated tool of analysis was discounted value and the central intellectual controversy centered on whether to use present value or internal rate of return to rank corporate investments. The subsequent evolution from this conceptual potpourri to rigorous economic theory subjected to scientific empirical examination was, of course, the work of many, but most observers would agree that Arrow, Debreu, Linter, Markowitz, Miller, Modigliani, Samuelson, Sharpe3 and Tobin were the early pioneers of this transformation" Nevertheless one can state that the development of modern portfolio theory began in 1952 with the pioneering work of Harry Markowitz and his subsequent publication on portfolio diversification in 1959iv. The objective of Markowitz was to develop a set of efficient portfolios, where the term efficient portfolio is taken to mean one which produces a maximum return for a given level of risk and vice versa. Since the groundbreaking work of Markowitz the expected utility hypothesis and the single period mean-variance model have made their presence felt in virtually all aspects of present-day financial planning. The latter method of portfolio selection does seem to have more attraction

owing to its intuitive appeal as well as "an almost perfect balance between elegance and simplicity" v(Grauer 1986). The expected utility hypothesis implies that an investor, who is faced with a set of alternative investment decisions, will chose that decision which will maximise the expected value of U(*), his preference or utility function. Nevertheless the expected utility hypothesis gives us a general decision 1 making framework that is only applicable to those investors who are 1 able to give the investment manager a comprehensive description of their attitudes towards risk [9]. Blake discusses a practical way of assessing an individual's risk profilevi. There are certain assumptions that are taken for granted in this approach to portfolio selection. Among these is that of perfect markets. In this thesis short sales, leverage and a riskless asset are not considered. The exclusion of the riskless asset does not affect the dynamic programming algorithm [12] that will be described in the following chapter. The expected utility is equivalent to the risk adjusted expected return on a portfolio. This is derived by subtracting the risk penalty from the expected return of the portfolio. The former component is contingent upon the portfolio risk as well as the investor's risk tolerance. The portfolio risk can be measured either by means of its standard deviation. Some authors prefer to measure riskvii by means of the mean absolute deviation, the interquartile range or the entropy of the portfolio. Turning to the mean-variance analysis of Markowitz we observe that, as this is essentially single period in nature, an investor who chooses this method of portfolio selection is said to be displaying myopic economic behaviour. Nonetheless, provided that the following necessary conditions listed below are satisfied, the investor will maximise his terminal wealth, WT: 1) The investor has a positive but diminishing utility of terminal wealth, in other words U'(WT) > 0 and U"(WT) < 0, 2) The investor has an iso-elastic utility function, in other words he displays constant relative risk aversion and, 3) his or her single period rate of return is a two parameter normal random variable. One should note that iso-elastic utility functions allow wealth and returns to be separated. Consequently the investor's utility can be maximised without reference to his or her end of period wealth. In this thesis we will be concerned with the following iso-elastic utility function, ( ) = / where < 1, and its quadratic approximation for short holding periodsviii ([25], [26]). We also examine the behaviour of the M-V approximation to the power function under the same conditions of risk aversion and investigate whether investors with similar risk aversion characteristics would hold similar portfolios using each programming model.
i

Elton, Edwin J. and Martin J. Gruber, 1975, Finance as a Dynamic Process, Prentice Hall

ii

Grauer, Robert R and Nils H. Hakannson, Higher Return, Lower Risk Historical Returns on Long-Run, Actively Managed Portfolios o Stocks , Bonds and Bills, 1936-1978, Financial Analysts Journal, 3 (1982), 39-53
iii

Mossin, Jan, Optimal Multiperiod Portfolio Policies, Journal of Business, 41(1968), 215-229.

iv

Markowitz, Harry M., 1959, Portfolio Selection:: Efficient Diversification of Investments, Wiley and Markowitz, Harry M Portfolio Selection, Journal of Finance, 1952
v

Rober R Grauer Normality, Solvency and Portfolio Choice, Journal of Financial and Quantitative Analysis, 21 (1986), 265-278
vi

Blake, David, 1990, Financial Markets Analysis, McGraw-Hill, Europe Elton, Edwin J. and Martin J. Gruber, 1975, Finance as a Dynamic Process, Prentice Hall

vii

viii

Ohlson, James A., The Asymptotic Validity Of Quadratic Utility as the Trading Interval Approaches Zero," in W. T. Ziemba and R. G. Vickson (Eds.), Stochastic Optimisation Models in Finance, Academic Press, NY, 1975. Pulley, Lawrence B., A General Mean-Variance Approximation to Expected Utility for Short Holding Periods, Journal of Financial and Quantitative Analysis, 16(1981), 361-373