Dynamic portfolio optimization: Time decomposition using the Maximum Principle with a scenario approach

We study a dynamic portfolio management problem over a finite horizon with transaction costs and a risk averse objective function. We assume that the uncertainty faced by the investor can be modelled or approximated using discrete probability distributions via a scenario approach. To solve the resulting optimization problem we use stochastic programming techniques; in particular a scenario decomposition approach. To take advantage of the structure of the portfolio problem we propose a further decomposition obtained by means of a discrete version of the Maximum Principle. The result is a double decomposition of the original problem: The first, given by the scenario approach, focuses on the stochastic aspect of the problem while the second, using the discrete Maximum Principle, concerns the dynamics over time. Applying the double decomposition to our portfolio problem yields a simpler and more direct solution approach which we illustrate with examples. (C) 2004 Elsevier B.V. All rights reserved.