Question

When accounting for transaction costs, why does the optimal turnover rate of a portfolio decrease as the estimated costs of buying and selling increase?

Accepted Answer

When you buy or sell stocks, you pay transaction costs. These are the fees charged by brokers and the small price gaps you lose when trading. Turnover rate is just how often you swap the stocks in your portfolio for new ones. Think of it like swapping out the items in your grocery cart; every time you put something back and grab something else, you pay a small fee at the register. If these fees are low, it is cheap to keep changing your cart to get the best items. But if the store suddenly raises the fee for every swap, it makes less sense to keep switching things around. Even if you think a new stock might perform slightly better, the cost of switching is now so high that it eats up any potential profit you hoped to gain. Because you want to keep as much of your money as possible, you choose to hold your current stocks longer rather than paying the high cost to move. Therefore, as trading becomes more expensive, you naturally trade less often to avoid those costs, which lowers your total turnover rate.

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When accounting for transaction costs, why does the optimal turnover rate of a portfolio decrease as the estimated costs of buying and selling increase?

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