Combining Transformer based Deep Reinforcement Learning with Black-Litterman Model for Portfolio Optimization

ArXiv ID: 2402.16609 “View on arXiv”

Authors: Unknown

Abstract

As a model-free algorithm, deep reinforcement learning (DRL) agent learns and makes decisions by interacting with the environment in an unsupervised way. In recent years, DRL algorithms have been widely applied by scholars for portfolio optimization in consecutive trading periods, since the DRL agent can dynamically adapt to market changes and does not rely on the specification of the joint dynamics across the assets. However, typical DRL agents for portfolio optimization cannot learn a policy that is aware of the dynamic correlation between portfolio asset returns. Since the dynamic correlations among portfolio assets are crucial in optimizing the portfolio, the lack of such knowledge makes it difficult for the DRL agent to maximize the return per unit of risk, especially when the target market permits short selling (i.e., the US stock market). In this research, we propose a hybrid portfolio optimization model combining the DRL agent and the Black-Litterman (BL) model to enable the DRL agent to learn the dynamic correlation between the portfolio asset returns and implement an efficacious long/short strategy based on the correlation. Essentially, the DRL agent is trained to learn the policy to apply the BL model to determine the target portfolio weights. To test our DRL agent, we construct the portfolio based on all the Dow Jones Industrial Average constitute stocks. Empirical results of the experiments conducted on real-world United States stock market data demonstrate that our DRL agent significantly outperforms various comparison portfolio choice strategies and alternative DRL frameworks by at least 42% in terms of accumulated return. In terms of the return per unit of risk, our DRL agent significantly outperforms various comparative portfolio choice strategies and alternative strategies based on other machine learning frameworks.

Keywords: Deep Reinforcement Learning, Black-Litterman Model, Portfolio Optimization, Dynamic Correlations, Long/Short Strategy

Complexity vs Empirical Score

• Math Complexity: 7.5/10
• Empirical Rigor: 8.0/10
• Quadrant: Holy Grail
• Why: The paper combines advanced theoretical frameworks (Transformer DRL, Black-Litterman Bayesian model, deterministic policy gradient) with empirical backtesting on real-world US equity data, demonstrating significant performance improvements over benchmarks.

  flowchart TD
    A["Research Goal: Enhance DRL for Portfolio Optimization by Integrating<br>Dynamic Correlation Knowledge for Long/Short Strategy"] --> B["Data Input: US Stock Market Data<br>Dow Jones Industrial Average Constituents"]
    B --> C["Methodology: Hybrid DRL-Black-Litterman Model"]
    C --> D["Computational Process:<br>Transformer-based DRL Agent Learns Policy<br>to Determine Portfolio Weights using BL Model"]
    D --> E["Outcome: Dynamically Optimized Long/Short Portfolio<br>Maximizing Return per Unit of Risk"]
    E --> F["Key Findings:<br>42%+ Higher Accumulated Return<br>Superior Risk-Adjusted Performance vs. Benchmarks"]