A Simple Algorithm for Optimal Portfolio Selection with Fixed Transaction Costs Author(s): Nitin R.

Patel and Marti G. Subrahmanya Source: Management Science, Vol. 28, No. 3 (Mar., 1982), pp. 303-314 Published by: INFORMS Stable URL: http://www.jstor.org/stable/2630883 . Accessed: 06/10/2011 05:25
Your use of the JSTOR archive indicates your acceptance of the Terms & Conditions of Use, available at . http://www.jstor.org/page/info/about/policies/terms.jsp JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range of content in a trusted digital archive. We use information technology and tools to increase productivity and facilitate new forms of scholarship. For more information about JSTOR, please contact support@jstor.org.

INFORMS is collaborating with JSTOR to digitize, preserve and extend access to Management Science.

http://www.jstor.org

MANAGEMENT SCIENCE Vol. 28, No. 3, March 1982 Priinted in U.S..

A SIMPLE ALGORITHM FOR OPTIMAL PORTFOLIO SELECTION WITH FIXED TRANSACTION COSTS*
NITIN R. PATELt
AND

MARTI G. SUBRAHMANYAMt

The general optimal portfolio selection problem witlh fixed transaction costs is a complex mathematical programming problem. However, by placing reasonable restrictions on the variance-covariance matrix of returns, it is possible to simplify the solutioni of the problem. Specifically, if the structure of returns between securities is such that the pairwise correlation coefficients are approximately the same, a fairly simple algorithm which requires little computational effort can be employed. This method can also be extended to.the case where changes in the information set necessitate a revision of an existing portfolio. (FINANCE; FINANCE-INVESTMENTS; PORTFOLIO SELECTION)

1. Introduction The pioneering work of Markowitz ([13] and [14]) in portfolio analysis has served as the basis for the development of much of modern financial theory. Two directions of enquiry have been pursued in the literature: one, the development of modern portfolio theory to optimize selection of portfolios under different scenarios and the other, the derivation of a theory of pricing of capital assets under uncertainty. One basic implication of most models in portfolio theory is that investors are well diversified in their holdings of securities. However, this implication of portfolio theory does not accord with the observed holdings of securities by investors, who typically hold a small number of securities.' While there are alternative explanations of this phenomenon, an important factor is the presence of transaction costs, broadly defined to include both direct costs such as brokerage commissions as well as the costs of analyzing securities, which are ignored in much of the theory. Though some attention has been focussed on the question of variable transaction costs, (see for example, Pogue [16], and Chen, Jen, and Zionts [3]), the question of undiversified portfolios remains unresolved. Variable transaction costs render individual securities less desirable but do not inhibit the addition of more securities to a portfolio. Fixed transaction costs such as odd-lot commissions do provide an explanation for the phenomenon of reduced portfolio size but this market imperfection has not been modelled in the literature, by and large. Mao [12], Jacob [9], and more recently, Levy [10] examine the fixed transaction costs problem indirectly by placing restrictions on the number of securities in the optimal portfolios. However, they do not explicitly relate the optimal number of securities to the transaction costs, and provide only a general rationale for the restriction. The only detailed analysis of the fixed transaction costs problem in the portfolio selection literature is by Brennan [2].2 Assuming that the structure of the Sharpe [18],
March1980.This paperhas beenwith the authorI monthfor I *Acceptedby MartinJ. Gruber;received
revision. 1i IndianInstitute Management, of Ahmedabad.

INew YorkUniversity.
'In a study by Blume, Crockett and Friend [1] for the tax year 1971, it was foulld that investors hold relatively undiversified portfolios. Based on a sample of individual income tax returns, it was computed that, among dividend paying stocks, 34 per cent held only one stock, 50 per cent held no more thanitwo anidonly I I per cent listed more thaniten stocks. 2Stapleton and Subrahmanyam [19] provide an analysis of the effect of fixed transactioni costs on equilibriulll prices. However, they are concerned more with asset prices with this market imperfection and do not deal with the optimal portfolio selection problem directly. They therefore use an enumilerationi method to solve the portfolio problem in order to determine equilibrium prices. 303 0025-1909/82/2803/0303$0 1.25
Copyrigiht 0) 1982, The Itistittite of Management Scietnces

304

N. R. PATEL AND M. G. SUBRAHMANYAM

Lintner [11] and Mossin [15] capital asset pricing model holds even under fixed transactions costs, Brennan presents a model for determining the optimal number of securities in the portfolio. Initially, he assumes that all securities have the same systematic risk and the same residual variance, and hence, in equilibrium, the same expected return, and derives the optimal number of securities. Subsequently, he relaxes the assumptions of identical residual variance, and through the capital asset pricing model, identical systematic risk. There are several difficulties with the Brennan formulation. Firstly, he needs to assume that the capital asset pricing model holds. While this may be a reasonable approximation, this pricing relationship is itself affected when several investors operate under fixed transaction costs as shown by Levy [10]. More importantly, this begs the question of superior access to information and consequently different estimates of the parameters of security returns, which imply that the standard capital asset pricing model may not be relevant to that investor. Indeed, if the capital asset pricing model were always valid, portfolio selection models are of dubious merit, except for the residual variance component which may not be significant, even with a relatively small number of securities. Secondly, the Brennan model focusses on the number of securities rather than on individual candidate securities themselves. Hence, the attractiveness or otherwise of an individual security cannot be examined except in the trivial sense that securities with lower residual variance are preferred, ceterisparibus. Finally, the computation of the optimal number of securities is quite complicated, an unattractive feature of many portfolio selection models from the viewpoint of practicing portfolio managers. The general optimal portfolio selection problem with fixed transaction costs is a complex mathematical programming problem. But, by placing reasonable restrictions on the variance covariance matrix of returns, it is possible to simplify the problem. Interestingly, the solution of the problem can be reduced to a fairly simple algorithm involving very little computational effort. In ?2, the model is discussed and a simplified form of the objective function is presented. The next section derives the algorithm and proves that the simple rules derived are optimal. A numerical example is worked out and explained in ?4. ?5 deals with the case where changes in the information set and/or the wealth constraint necessitate a revision in the portfolio. In this case, the relationship of additional securities to the existing portfolio has to be taken into account. 2. The Model The portfolio selection problem of the investor in a mean-variance context with fixed transaction costs can be written as:
11 s1 17 n

Max

i=

xiRi + xoR- ai i1
Z1

j=1

x x1sis1p1- t i =1

Yi

(1)

subjectto
i=l

xi+?xO=W
=

where the xi are unrestricted in sign, yi = 0 or 1, and xi # 0 only if yi definition of the variables are as follows: = 1 if security i is part of the portfolio; i = 1, 2, . .. , n. = 0 otherwise. xi = amount invested in (risky) security i; i = 1, 2, ... , n. xo= amount invested in the riskless security. Ri= 1 ? expected rate of return on security i; i =1, 2, . . ., n.

1. The

OPTIMAL PORTFOLIO SELECTION WITH FIXED TRANSACTION COSTS

305

R = 1 + rate of return on the riskless security. a = risk aversion factor of the investor (a > 0). Si= standard deviation of the rate of return on security i; i = 1, 2, . , n. pij = correlation coefficient between the returns on securities i and j; i, j = 1, 2, . . .,n. t = fixed transaction cost incurred for each risky security included in the portfolio. This cost is assumed to be incurred at the end of the period. Equivalently, the fixed transaction cost per security at the beginning of the period is equal to t/R. W = initial wealth of the investor. The first term refers to the mean end of period cash flow to the investor from holdings of risky assets. The next term relates to the return from the riskless asset. The third term is the variance of end of period cash flow, while the last term refers to the fixed transaction cost. The above formulation appears to be similar in form to the standard Markowitz model with a riskless asset, except for the term involving the fixed transaction cost.3 However, there is a basic difference; in this model, the computation of the mean return and the variance of the return of the portfolio takes into account only those securities that are in the portfolio rather than all the securities available in the market. This aspect of the problem complicates it considerably, since it becomes a mixed-integer quadratic programming problem for which no simple solution method exists. At this point, there are two possibilities. The first would be to simplify the structure of the model by placing some restrictions on the parameters. The other method would be to obtain an approximate solution to the problem as formulated. We have chosen the former alternative. One possible restriction on the structure of returns is that all pairwise correlation coefficients between security returns are equal. While this assumption is difficult to justify on any conceptual grounds, it has been shown to be a reasonable assumption, empirically. In a study of alternative methods of forecasting the correlation structure of returns, Elton and Gruber [4] demonstrate that this assumption produces better estimates of the future correlation structure of security returns than do correlation coefficients based on historical returns which may differ across pairs of securities, the most general specification possible. Surprisingly, another intuitively appealing simplification, the single index approximation of Sharpe [17] does not perform as well as the constant correlation assumption. In the Elton and Gruber study, the assumption of a constant correlation coefficient produced forecasts that were more accurate than nine other specifications that were tested. In a more recent study by Elton, Gruber, and Urich, [8], the forecasting performance of the constant correlation coefficient assumption is tested using a variety of statistical procedures. The performance of this assumption is consistently superior to that of all the alternatives in each of the statistical tests performed. The constant correlation coefficient assumption will be used in the rest of this paper.4 Suppose we assume that
pUj= p

for all i, j; i #/ j (p > 0).

3In this formulation, we have chosen to model the fixed transaction cost as leading to a reductioll in the mean end of period caslhflow. An alternative formulation would be to treat it as a reduction in the resources available for investment, with the cost appearing in the wealth constraint. As will be clear in the analysis later on, the two approaches are formally equivalent. 4The fixed transaction costs problem using the simplified structure suggested by the single index model of Sharpe [17] will be analyzed in a subsequent paper. However, it turns out that the solutioni technique for this case is more complex than the case studied here. The structure of the single-index model does not permit the decomposition analyzed in this paper, since the interactions due to the integer constrainits become more difficult to handle.

306

N. R. PATEL AND M. G. SUBRAHMANYAM

The variance of the end of period cash flow can be written as

n p i=1 j=1 n xXjjsjsj + n1 E X12Si i=1
fl

i#&j
n
n1

=p>E
i=lj=l

j + (_1p)

X)2SI. E
i=1

The portfolio selection problem of the investor becomes

Max
Xi

> x,RJ ? xOR-t i=1 yi-a E i=1

E xi + x0 = W
i= 1

17

17

* x1x1ssj + (1-p)
i=1
E

i=1 y =1

xsi2

subject to

and yA= 0 or 1; xo, xi are unrestricted in sign with the proviso that xi #/ 0 only if Yi= 1. If the securities chosen to form the portfolio belong to some set S c (1, 2, .. , n, then yj = 1 for j C S and yj = Xj= 0 for j 4 S. Eliminating xo using the wealth constraint, the objective function becomes a concave function of xj, j C S. Taking derivatives gives us the following necessary and sufficient5 conditions for optimal levels of xj, given S. (R1 - R) or
-

j 2aps

sixiS-2a(1

_p)s,.x1=0,

]C

S,

(3)

x. =

2 0O,

(lp)s

j4S

jI 4 S.

Sincey1 = 1 if and only if xj #0 ,

Rj -s(

p)

PE (i

pj y,iji

1,25 ... ., n.

(5)

Multiplying (5) by sj and adding over all j E S, we get

ES

E sx,

jS E

R. 2as1 -p) (I

- R

MEmp E

i-

wherem=jSj

iS

so that
iES

2a[mp + (I -p)]

S s

(6)

Substituting (6) into (5) yields

=

(Rj

R)yj

pyjEiEs(Ri

-R)si

2a(l _ p)S>2
djy]

2a(

- p)[(m-

I)p + I ]sj j 1 5..n

n

2a(1-p)s?

pyjziE~sciyi 2s 2a(1-p)[(m-1) +p1] j=I1

7
(7)

sThe first order condition is sufficient since the objective function after substituting the constraint is concave.

OPTIMAL PORTFOLIO SELECTION WITH FIXED TRANSACTION COSTS

307

where cj = (R - R)/sj represents the excess return of security j over the riskless rate of return as a ratio of the standard deviation of the return of the security. Multiplying (3) by Xj, adding over j E S, and rearranging, we get p 2 SiS (I sjs~xix~?j+-p)

~~~(Rj -R)
j~s, y es

i e i~~Sj~~S Sje s

s]xj2=
jx

ye Ss

2a

7.(8)

Substituting for x0 in the objective function, using the wealth constraint, and using (8), the objective function becomes
n j=1

2, (Rj - R)xjl2-

tm + WR.

(9)

Substituting for xj from (7) the objective function expressed in terms of y. becomes 4a(1l_-p)
1 -' Yj-

[(m-

tm - WR.

(10)

For fixed m, since a, p, t, w, R are constants, our problem is reduced to Max cj2y1

j=ll

[(in-I)p and

+ 1](J
yj = m.
j=l

subject to yj =0,l

We assume that the securities have been ranked so that cl > C2 . .. > c,7- Note if two securities have the same ci, they may be treated as a single security in our analysis, so that the strict inequalities above do not imply any loss of generality. 3. The Algorithm

We are now in a position to derive a simple algorithm for portfolio selection and show that it is optimal.
THEOREM 1. Let S be the set of optimal securities for a given number of securities chosen, m, m >.2 (i.e., ISj = m and S = (k I Yk = 1}). Then there is no j E S such that both] - 1 andj + 1 X S.

We argue from contradiction. Suppose there is such a j. Let S' = S - (j}. Let OFV ( Q) denote the objective function value for any set of indices Q.
OFV (S)= S O

iES
Ec

1.c7
-

[(m-I)p
(

+ 1(is Ec1)/
( E ci)

(11)

-S[(i

l)p [ lM 1]
cI
2pcki
v

[i

)p? 1]

cj*

(12)

OFV(S'U{]-1})=

[(m-2)p

13

308 Since OFV(S)

-

N. R. PATEL AND M. G. SUBRAHMANYAM

OFV(S'U { j(j 2P

1}) > 0

[ (m-1)p + 1
or

lcj)

iE c - [ (m -2)p + I ] (CJ_lc /-)

>

(ci- I - c.) t2p

ci - [ (m - 2)p + I ] (cj-, + cj)) > O

(14)

and since cj- l - cj > 0, the expression within the curly brackets above (call it (a)) must be greater than or equal to zero. A similar argument using OFV(S) - OFV(S'U{j ? 1}) > 0 leads to (cj+I-cj){2p E ci-[(m-2)p 1(cI + + c)
>0

i E-sI

and since cj+I - cj < 0, the expression within the curly brackets above, (call it (b)), must be less than or equal to zero. Subtracting (b) from (a) we have

[ (m -2)p + I I(Ci+ I- ci- ) >1 .

For m > 2, the first factor above > 0 which implies cj+I > cl which is a contradiction. Q.E.D. We conclude from Theorem 1 that for a given m, the optimal S is of the form l 1 {1, 2, ... , u, 1, + 1, . . ., n} where u + n-I + = m. In fact, an optimal portfolio can be represented by the single number u, since 1 = n - m + u + 1. We shall therefore say that an optimal portfolio is u* to mean that the securities in the portfolio are {1,2, . . ., u*,l*,l* + 1, . . ., n} where l*= n-m + u* + 1; if u* = m, l* = n + 1 and the portfolio represented in this case will be { 1, 2, . .. , m}.
v THEOREM Let u,*, U*1 + be optimalportfolios of sizes m and m + 2. , + n-rn +?u* + 1 and i+H = n - (m + 1) + u*1 + 1 =n-rm u
U,+

1 respectively.Let
u* +
.

1=

Then

u* +

>

U,*

if p > 0 and c1 > 0.

(i) We first show u,*7 1 > u,s*+. We argue from contradiction; suppose u,*+? ? u* ?2. Since u,* is optimal, increasing 1/*7and u,* both by 1 cannot increase the objective function value. From this we conclude
cl (C
-

cl*){ 2p (Eci
/,*)*,+ C \i=

[ (i

+ ) 2)p + 1] (c,,,* + ? cl*) ? 0. )I

Since the first factor above > 0, the expression in curly brackets (call it (c)) > 0.
Under the hypothesis,
1*l=

U*[ +

> u*
+l

2, so that
U,, +

n-m

+
?,+

n- nm +

2 > n

U,,

? 1= l,+

.
1*,

Also, since u,*7? is optimal, if we exchange security u,* + 1 with security objective function value cannot irncrease.From this, we conclude
0 t{221 [/tI1+I fl

the

(c,*

c,*?1){2(12p
t

c+
i=

i=l

?2

ci +
i=l,*,+,

ci

[(

- 2)p + 1](cl

C"* +

> ?.

OPTIMAL PORTFOLIO SELECTION WITH FIXED TRANSACTION COSTS

309

The first factor above being < 0, implies that the expression in the curly brackets (call it (d)) < 0. Subtracting (d) from (c), we have

2p
i = l,,+ I

ci -

2
i=U,*,+2)

ci > 0.

Since p > 0,
+ I-, I' + X n-rn + tu,* + Xtil +I

E
i l,+

ci= i=,*

E
+2

ci=

i = n7-77n + ti* +2

ci-

E
i = t* +2

ci>

0.

However, since ci > 0, the above expression is less than

n-rnm+, 2 *
U,*

ci1+2 i=u*+2

ci

(C,11+i

i=n-m+u,*,

i=ti*+2

ci) <0

since c,,_1+ i < ciThis leads to a contradiction. It follows that u,* + 2 > u*1 and hence, we conclude that u* + 1 > u*+ (ii) To show that u, + > u*, we follow an exactly analogous argument but decreas-

ing u + l and ',*t+Il by 1. Q.E.D.

we need only to check This theorem tells us that if we have u,*, then to find u* for which value of the pair u,*,u,*+ 1 the objective function is larger. Theorems 1 and 2 directly suggest an algorithm for finding the optimal portfolios for different values of m, for m = 1,2, . .. , m. This algorithm is flow-charted in Figure 1. It is easy to show that the computational complexity of the algorithm is 0(n) and is, therefore, very efficient. (If we include the effort involved in sorting the securities in increasing order of ci, the algorithm is O(n log n).) Once the optimal portfolios S*, S*, . . . f, S, for each value of m are obtained, we can determine that best portfolio for a given a and t by evaluating expression (10) for S*, S*. .., S,1.If expression (10) has a maximum value for Sk*i then Sk is the optimal portfolio. Next we prove an interesting characteristic of optimal portfolios. 3. Let S,*,= { l,2, . .. , u, 1,1 + 1, . . ., n} be the optimal set of securities THEOREM for a fixed m (l > u + 1). Then securities 1, 2, ..., u are bought long and 1,1 + 1, . . ., n are sold short. Since S* is optimal, its objective function value is not less than for the portfolio ,u -l, I l, 1, ...,n}. Sm 1={l, 2, OFV(S*,)
-

OFV(S,?I) = (c,1 I

c,) {2p E ci - [((m

2)p + I] (c,l ..,u-

+ c,,)} l, l,.. .,n.

where S' = 1,2,. Now (c lcl,) < 0, so that

2p E ci- [(m -2)p + I ](cI- ,+ cl,) < 0

i (= sI

or ](cl [(m-2)p + IlI _I + cl,) > 2p ci.

310

N. R. PATEL AND M. G. SUBRAHMANYAM

Start

OFVt=

OFV( I)

l,
-

+ -1')
es

> OFV( S,, U1[(

+ 1]=-

~~~~~No
+ I -p)+[( I Ul)*p 1] ?

S,*a+,( S-*p)U[(

-*l

FIUE.Te

S,*,, Sincec11 > c,<,~~~~~~~~~~~~~~~~~~~~~~1

|OFV,*, +,

Algorthm
OFV(

+,

No
Yes

FIGURE 1.

The Algorithm.

Since c,, > cl_ I,

[ From (7)
c,,[(M-l)p

(m-l2)p+l1]ci

l)>p + Ici]
i s

IIl

2as" (I1-p)
<

+ I ]-p PZE -s,*c; [ (m-1 I)p + I

]pZE c,,[(m -2)p + I] 2as" (I1-p)

sc
0.

[ (m-1 I)p + I

Since both numerator and denominator

are greater than zero, it follows that xl*

Now for all j

u,
Cj[ (M 1).p+ I>c"[ (M )p + I>p E
i (E s,*,

Cj

so that Xj*> O for all j = 1, 2, ... ., u.

>

An analogous argument shows that x* . n. Note also that s ,xl > s X* > Q.E.D. Sl 2X*+2>*** SX,.
... (The proo>olw ill fro (7)).

< O and hence Xj*< O for all j = 1,1I + s X* > ***> S- XI* and s,x* > s,+ x*

1,

OPTI-MALPORTFOLIO SELECTION WITH FIXED TRANSACTION COSTS

311

4.

A NuI11erical ExaInple

We give below illustrative results for a hypothetical problem in which n = 20, p = 0.4, t = 1, a = 0.01 and sj = 1 forj = 1,2, . . ., 20. The Cjwere chosen randomly in the interval (0, 1).
=

0.875,

c2 = 0.839,
C7 = 0.413, C12 =0.231, C17 = 0. 120,

C6 = 0.429,

C3= 0.719, c8 = 0.331, c13 =

cX = 0.245, C16 = 0. 142,

0.209,

C4 = 0.585, c9 = 0.326, C14 =0. 168, C19

0.080-

C5=

C18= 0.1 I cI

c10 = 0.312, 0.464, C15 = 0. 152, C20 = 0.062.

in]

Sfl* [1] [1,2] [1,2,20] [I to 3,20]

[I to
3? 19?

OFV,* 0.4594 0.8823 1.3904 1.8888

20] 2.5393

Expression (10) 18.1408 24.2574 29.1859 31.7720

35.6939

I 2 3 4
5

6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

[I to 3, 18 to 20] [I to 3, 17 to 20] [I to 4, 17 to 20] [1 to4, 16 to 20] [I to 4, 15 to 20] [I to 4, 14 to 20] [I to 5, 14 to 20] [I to 5, 13 to 20] [Ito 6, 13 to 20] [I to 7, 13 to 20] [I to 7, 12 to 20] [I to7, 11 to 20] [I to 8, 11 to 20] [I to 9, 1Ito 20] [I to 20]

3.1414 3.7304 4.3901 5.0278 5.6496 6.2477 6.8688 7.4439 8.0365 8.6090 9.1894 9.7539 10.2828 10.8108 11.3384

37.6303 38.7151 40.1371 40.8788 41.1735 41.0642 41.0002 40.4762 40.0009 39.3495 38.6991 37.9204 36.9295 35.9329 34.9341

The optimum value of m is 10 with the best portfolio S*, given by

S=

[1,2,3,4,15,16,17,18,19,20].

From (7) the optimal investments in the securities are: x = 46.2137, x 2* 43.2137, X = 33.2137,
X =*= x
= -

22.0471,

14.0362, 14.8696, X*= - 16.7029, x*= - 17.4529, x*= -20.0362, x*0= -21.5362. The optimal investment in the riskless security is x
= 20

W-

jxi = W- 40.0542.
i. =I

312

N. R. PATEL AND M. G. SUBRAHMANYAM

5. The Portfolio Revision Problem The analysis presented in the previous section deals with the case where an investor optimizes his portfolio holdings of risky securities with fixed transaction costs under the assumption that the investor's initial wealth is in the form of cash. While this accurately describes the initial portfolio problem of the investor, it does not properly reflect the costs of changing the optimal holdings over time. Specificially, there may be a reluctance on the part of the investor to decrease the holding of a particular security in light of adverse information on, say, its expected return since there are fixed transaction costs incurred in selling this security as well as investing the proceeds in one or more other securities. It may be reasonably hypothesized that the optimal holdings of securities in the portfolio after revision will be biased in favour of securities that are initially included in the portfolio. It turns out that the portfolio revision problem can be modelled with minor changes in the earlier analysis. Suppose xi is the amount already invested in the security i (the present portfolio) and di is the change in this amount (the new portfolio). The maximization problem in equation (2) can be modified as
n
fl

Max
di i=Ii

(xi +di)Ri+
n
(afl

(xo + dO)R- t

yi
I

n1s
E12

1(2+dyss

l-)E(x

js

(5

subject to

Ed

+ do = W'

where W' is the additional amount available for investment and with the proviso that Yi = 1 if di #- 0, i = 1, 2, . .. , n. It should be noted that W' could be zero, positive or negative and does not impose any restrictions on the problem. If the problem is one of portfolio revision merely due to changes in the information set, W' would be zero; if there are additions to or redemptions from the portfolio, from other income or due to consumption needs, W' would be positive or negative respectively. The portfolio problem can be rewritten by grouping separately the terms involving the di's, the decision variables, in (15).
n n

Max
di=

d1Ri+ doR-t
-

y
I

-a tpL
n

(dxjsisj + d)x1s.s1+ did sisj) + (I p)

d + do = W',
i= I

2dixis2

+ d2SJ2j

+ K

subject to

Yi= I if di ::--0,
where
12

i= 1,2,

.. n,

(16)

171

;~~~~~ xi_ss 1

xiRi+ xoR7-a

p)
i _ 1) ;

Xi2si2

OPTIMAL PORTFOLIO SELECTION WITH FIXED TRANSACTION COSTS

313

which is unaffected by the portfolio revision. Equation (16) can be rewritten as Max,1d,[R
-

2aps(1
1 r

xs-

2a(1 -p)s,xij
11 11 A

11

+ doR-t

fi-af

p~2 '

d,dj,s1sj+(1 -p)

2 aj2s7 9(17)

subjectto

E=
1=1

4j+d
1 if d,i#0,

y=

i =1,2, ... , n.

This is of the same form as the original problem in (2), except that
=

[R

2apsi(

2a(I -

A),2x1

The rest of the analysis would be similar and the same procedure as before can be used to solve for the optimal d1's.Intuitively, the only difference between the initial problem and the portfolio revision problem is that the interactions of each security with the existing portfolio as reflected in the definition of R,' have to be taken into account in the latter case. It pays to revise the existing holdings of a particular asset only if the round trip transaction costs can be recouped by revising the portfolio. 6. CoIiclusions

This paper derives simple decision rules for optimal portfolio selection under fixed transaction costs. Assuming that the pairwise correlation coefficient is the same across all securities, it is shown that the optimal portfolio can be chosen without directly solving the complex mixed-integer quadratic programming problem. The interesting feature of the model is that securities can be ranked on the basis of a simple index, the ratio of the excess return to the standard deviation of return of the security. Thus, even fairly large problems can be solved by hand, as convergence to the optimal solution is rapid. Even for cases where the assumption of equal correlation coefficients is not valid, perhaps an intuitive understanding to the solution of a fairly complex problem can be gained. The portfolio revision problem is shown to be similar in structure to the problem of the portfolio optimization starting with cash holdings, the difference being that in the former case, round trip transaction costs lead to a reluctance to revise the portfolio unless the gains are correspondingly greater.
References
1.
BLUME,

M. E.,

CROCKETT, J. AND FRIEND, I., "Stock Ownership

in the United States: Characteristics

and Trenids," Survey of ClurenitBusiness, Vol. 54, No.

11 (November 1974), pp. 16-40.

M. J., "The Optimal Numllber Securities in a Risky Asset Portfolio WheniThere Are Fixed of Costs of Transacting: Theory and Some Empirical Results," J. Finianicial QlanititativeAnial., Vol. 10, No. 3 (September 1975), pp. 483-496. 3. CHEN, A. H. Y., JEN, F. C. AND ZIONTS, S., "The Optimal Portfolio Revisioni Policy," J. Blusiniess, Vol. 44, No. 1 (January 1971), pp. 51-61. 4. ELTON, E. J. AND GRUBER, M. J., "Estimating the Depenidenice Structurle of Slhare Pr-ices," J. Finance, Vol. 28, No. 5 (December 1973), pp. 1203-1232. 5. AND PADBERG, M. W., "Simple Criteria for Optimal Por-tfolio Selection", J. Finance, Vol. 31, No. 5 (December 1976), pp. 1341-1357.
BRENNAN, 6.

2.

AND

"Simiple

Criteria

for Optimal

Portfolio

Selectioni

With

Upper

Bounlds,"

OperationsRes., Vol.

25?

No. 6 (November-December 1977), pp. 952-967.

314
7. 8. 9. 10. 11. 12. 13. 14. 15. 16.

N. R. PATEL AND M. G. SUBRAHMANYAM

ELTON, E. J. AND GRUBER, M. J., "Simple Rules for Optimal Portfolio Selection: The Multi Group

17. 18.
19.

Case," J. Financial QuantitativeAnal., Vol. 12, No. 3 (September 1977), pp. 329-345. , AND URICH, T. J., "Are Betas Best?" J. Finance, Vol. 33, No. 5 (December 1978), pp. 1375-1384. JACOB,N. L., "A Limited-Diversification Portfolio Selection Model for the Small Investor," J. Finance, Vol. 29, No. 3 (June 1974), pp. 847-856. LEVY,H., "Equilibrium in an Imperfect Market: A Constraint on the Number of Securities in the Portfolio," Amer. Econom. Rev., Vol. 68, No. 4 (September 1978), pp. 643-658. LINTNER,J., "The Valuation of Risk Assets and the Selection of Risky Investments in Stock Portfolios and Capital Budgets," Rev. Econom. Statist., Vol. 51, No. I (February 1965), pp. 13-37. MAO, J. C. T., "Essentials of Portfolio Diversification Strategy," J. Finance, Vol. 25, No. 5 (December 1970), pp. 1109-1121. MARKOWITZ,H., "Portfolio Selection," J. Finance, Vol. 7, No. I (March 1952), pp. 77-91. , Portfolio Selection: Efficient Diversificationof Investments,Wiley, New York, 1959. MOSSIN, J., "Equilibrium in a Capital Asset Market," Econometrica,Vol. 34, No. 4 (October 1966), pp. 768-783. POGUE, G. A., "An Extension of the Markowitz Portfolio Selection Model to Include Variable Transaction Costs, Short Sales, Leverage Policies and Taxes," J. Finance, Vol. 25, No. 5 (December 1970), pp. 1005-1028. SHARPE,W. F., "A Simplified Model for Portfolio Analysis," Management Sci., Vol. 9, No. 2 (January 1963), pp. 277-293. , "Capital Assets Prices: A Theory of Market Equilibrium Under Conditions of Risk," J. Finance, Vol. 19, No. 4 (September 1964), pp. 425-442. M. STAPLETON,R. C. AND SUBRAHMANYAM, G., "Market Inperfections, Capital Market Equilibrium and Corporation Finance," J. Finance, Vol. 32, No. 2 (May 1977), pp. 307-320.