Optimal mean-variance portfolio selection (Q513742)

The authors consider an investor who has an initial wealth which he wishes to exchange between a risky stock and a riskless bond in a self-financing manner dynamically in time so as to maximise his return and minimise his risk at the given terminal time. The return is identified with the expectation of the terminal wealth and the risk with the variance of the terminal wealth. Assuming that the stock price follows a geometric Brownian motion and the bond price compounds exponentially, the authors first consider the constrained problem in which the variance is bounded above by a positive constant (or the expectation of the terminal wealth is bounded from below by a positive constant). An application of Lagrange multipliers implies that the Lagrange function for either/both constrained problems can be expressed as a linear combination of the expectation and the variance of the terminal wealth with opposite signs. Optimisation of the Lagrange function over all admissible controls thus yields the central optimal control problem under consideration. Then, conditioning on the size of the expectation it is shown that the second application of Lagrange multipliers reduces the nonlinear optimal control problem to a family of linear optimal control problems. Solving the latter using a classic HJB approach it is established that the optimal control depends on the initial point of the controlled wealth process in an essential way. Finally, it is shown that the dynamic formulation of the nonlinear optimal control problem admits a simple closed-form solution in which the optimal control no longer depends on the initial point of the controlled wealth process and hence is time consistent.