An Algorithm for Portfolio Trades with Transaction Costs

Abstract

Optimal portfolio weights must be computed against the total committed wealth net of all transaction costs. Consequently, portfolio weights normally computed without regard to transaction costs may not be optimal and result in wrong trade recommendations. In particular, when portfolios are rebalanced, an increase (decrease) in portfolio weights may not necessarily mean that a security ought to be bought or sold. This would be so, especially if one considers the investors’ desire to hold a certain amount of cash in their portfolio. This article considers explicitly the trading costs of the portfolio and develops a simple trading rule consistent with the investors’ desired cash requirement.

TOPICS: Equity portfolio management, risk management, portfolio construction