Entropy Regularization under No-Shorting: Structure Preservation and Convexity in Dynamic Mean-Variance Portfolio Selection

Xinagyu Cui, Xun Li, Ziyan Li and Yun Shi

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Abstract: This paper studies entropy regularization for the discrete-time dynamic mean--variance portfolio problem with no-shorting constraints. In the unconstrained setting, entropy regularization can be introduced without changing the basic quadratic structure of the dynamic program. Under no-shorting, this property is lost: a standard fixed-temperature formulation generally preserves convexity but no longer preserves the homogeneous Bellman structure and the associated piecewise-linear feedback form. We introduce a state-dependent temperature that is matched to the homogeneity of the original mean--variance problem. This restores the piecewise-quadratic value function and the finite-dimensional Bellman recursion. The resulting formulation, however, makes convexity depend on the continuation coefficients generated by the soft recursion. We show that negative continuation coefficients lead to loss of convexity and prove that a common sufficiently small temperature preserves the Bellman structure and convexity over the entire finite horizon. The original no-shorting solution is recovered as the temperature vanishes. We also develop a sample-based implementation for unknown return distributions. Numerical and empirical results illustrate both the structural advantage of the state-dependent temperature and the practical relevance of the convexity-preserving temperature restriction.

Date: 2026-10
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