Optimal investment strategy

Mechanics, discrete, statistics, ...
btilly
Posts: 44
Joined: Fri Sep 26, 2008 7:45 am

Optimal investment strategy

(I've noticed a lack of Calculus in the P.E. problems. I don't know if that is deliberate, but solving this problem does require some Calculus. Though substantially less than you might think.)

In investing we are faced with many different choices for what to do with our money, each of which has its own risk/reward profile. Investment books suggest that we diversify our investments - don't put all of your eggs in one basket. But what is the best diversification strategy?

This can be studied in simple cases. For example we can look at an investor in a simplified model by giving him the same choice at time t0, t1, t2, and so on. At each step the investor divides his money between two options. One choice is to keep the money as cash, in which case it survives to the next time point unchanged. The other is a risky investment that 1/3 of the time will lose all of its value, and 2/3 of the time will double in value. The investor will invest a fixed fraction of his money in each option at each point in time. The goal is to find the investment strategy that will, with 100% odds, eventually beat any other investment strategy.

Obviously you want at least some of your money to be in the risky investment, because it has better than even returns. But equally obviously if you put all of your money in the risky investment then at some point you will lose all of your money, which loses to every other investment strategy. Somewhere between there is a happy medium.

In this case the happy medium is to risk 1/3 of your money, and to keep 2/3 of it in the form of straight cash.

Let us make this more complicated. At each step let us give our investor a choice of 4 investment options. The first is cash. Investment A will, as before, 2/3 of the time double your money, and 1/3 of the time will lose it. Investment B is riskier with higher rewards still. 2/3 of the time when A doubles your money, B multiplies it by 4 instead. Otherwise B loses your money. And investment C has even odds of tripling your money.

What is the optimal investment strategy now? That is, what division of money between Cash, option A, option B, and option C will, in the long run, beat any other possible way of dividing your money at each step?

stijn263
Posts: 1505
Joined: Sat Sep 15, 2007 11:57 pm
Location: Netherlands

Re: Optimal investment strategy

In this case the happy medium is to risk 1/3 of your money, and to keep 2/3 of it in the form of straight cash.
I think this depends on your risk preferences. Without specifying your risk utility function any amount could be a good strategy

btilly
Posts: 44
Joined: Fri Sep 26, 2008 7:45 am

Re: Optimal investment strategy

stijn263 wrote:
In this case the happy medium is to risk 1/3 of your money, and to keep 2/3 of it in the form of straight cash.
I think this depends on your risk preferences. Without specifying your risk utility function any amount could be a good strategy
In the problem I said, "The goal is to find the investment strategy that will, with 100% odds, eventually beat any other investment strategy." This condition is enough to uniquely specify the optimal investment strategy.

In a real world investing scenario this condition is similar to, "You're a young person with a very long investing horizon." Which means that you (should) have very high risk tolerance.

btilly
Posts: 44
Joined: Fri Sep 26, 2008 7:45 am

Re: Optimal investment strategy

Since nobody seems to be nibbling on this, I'll drop a hint.
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btilly
Posts: 44
Joined: Fri Sep 26, 2008 7:45 am

Re: Optimal investment strategy

In case anyone is curious, I'll outline the solution.
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