Journal of Investment Strategies

Risk.net

Risk constraints for portfolio optimization with fixed-fee transaction cost

Michael J. Hirsch and Nicole Navarro

  • Transaction costs should be explicitly considered in any portfolio allocation model.
  • Conditional Value-at-Risk is a good risk measure to use to limit down-side volatility.
  • Mean Absolute Deviation (approximation of Markowitz Mean-Variance) does not perform well, even when explicitly considering transaction costs.

Depending on the size of the initial investment, transaction costs are an important consideration when it comes to smartly investing money and growing a portfolio for retirement. In addition, different risk models significantly affect the growth rate of a portfolio. Many investment brokerages (eg, Fidelity, T. Rowe Price, etc) now employ fixed-fee transaction costs for individual investors. In this research, we investigate how fixed-fee transaction costs affect portfolio rebalancing. We use two risk measures, conditional value-at-risk and mean absolute deviation. Historical Standard & Poor’s 500 data is used for a computational study in which we compare the two risk measures and investigate how influential transaction costs are on the value of a portfolio at each investment opportunity.

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