Dynamical optimization theory of a diversified portfolio

We propose and study a simple model of dynamical redistribution of capital in a diversified portfolio. We consider a hypothetical situation of a portfolio composed of Ai uncorrelated stocks. Each stock price follows a multiplicative random walk with identical drift and dispersion. The rules of our model naturally give rise to power law tails in the distribution of capital fractions invested in different stocks. The exponent of this scale free distribution is calculated in both discrete and continuous time formalism. It is demonstrated that the dynamical redistribution strategy results in a larger typical growth rate of the capital than a static "buy-and-hold" strategy. In the large N limit the typical growth rate is shown to asymptotically approach that of the expectation value of the stock price. The finite dimensional variant of the model is shown to describe the partition function of directed polymers in random media. (C) 1998 Elsevier Science B.V. All rights reserved.