Portfolio Choice with Investor Specific Transaction Costs

Abstract

Recent works by Brennan [1; 2], Stapleton and Subrahanyam [7], Goldsmith [3], and Mayshar [5; 6] examine the effects of transaction costs on portfolio choice. All demonstrate that market equilibrium obtains when the standard assumption of zero transaction costs is relaxed. In each case transaction costs are considered exogenous to the model and identical for all investors. Therefore, each investor faces the same set of constraints. Although these refinements add new insight into the determination of market prices, the only light they shed on the actions of individual investors is to show that individuals who are confronted with transaction costs might fail to diversify completely their portfolio holdings.' Casual observation indicates that complete diversification by investors is rare and that the mix of risky securities in one's portfolio differs significantly among investors. Some individuals hold no risky assets while others tend to hold only the most speculative securities in the risky component of their portfolios. This behavior is in sharp contrast to the predictions of the standard models and has been explained previously through ad hoc assumptions about risk preference and market imperfections. In the model developed below we argue that such behavior by investors is rational and predictable if transaction costs are investor specific. These findings hold without having to rely on homotheticity, risk preference, or market imperfection assumptions. This paper has two objectives. The first is to show how changes in transaction costs affect the portfolio frontier and thus, the risk premium and optimal market portfolio facing the individual investor. The second is to identify individual characteristics of investors which affect the level of transaction costs. In section II a model based on Hirshleifer's [4, 277-301] formulation of the standard mean-variance intertemporal choice model is developed. Transaction costs for both the riskless and risky securities are added to the basic model, and the implications of this refinement are examined. An increase in the transaction costs of the risky securities is found to decrease the risk premium for the individual investor and to change the security mix of his market portfolio. An increase in transaction costs for the riskless securities has the opposite effect. In section III the implications of the model are considered and the conclusions are briefly summarized.