The Opportunity Cost of Inaction in Financial Markets: An Analysis of Institutional Decisions and Trades

Abstract

The ability of mutual funds, pension plans, endowments and other institutions to generate higher risk-adjusted return for the investors and beneficiaries is ideally measured by examining the stock returns from the point in time when they decide to implement a portfolio buy or sell decision to the point in time when they decide to reverse their position. However, the actual performance of a portfolio manager or an investment strategy can deviate significantly from the ideal paper performance. This implementation shortfall of institutional trading has two basic components. The first, execution cost, relates to the transactions you actually execute and arises from price impact, commission, and other transaction fees and taxes. The second, opportunity cost, relates to transactions that you fail to execute. We propose to present the first comprehensive analysis of an often ignored component of implementation shortfall -- the opportunity cost of unexecuted institutional decisions. The proportion of total decisions partly or wholly unfilled is 8.36% and the mean unfilled rate within the unfilled decisions is 51.64%. Opportunity costs of this failure to trade are 24 basis points or $20 billion in our sample period, much higher in magnitude when compared to price impact and five times that of commissions. There is a significant asymmetry in opportunity cost of buy versus sell decisions based on whether market conditions are bullish or bearish. Our initial pilot tests show that the opportunity costs decrease with firm size, speed of transaction, number of brokers, and exchange listing whereas they increase with market volatility.