Understanding Stock Transaction Costs

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Understanding Stock Transaction Costs

 

 

There are transaction costs in managing actual portfolios, but there are no transaction costs attributed to the hypothetical portfolios repre sented by market indexes. This problem is a bit more difficult. Returns on actual portfolios should be calculated after deducting all transaction costs, but comparisons with the indexes should be made only after crediting back to the actual portfolios unavoidable transaction costs. The portfolio manager cannot avoid the cost of investing new capital or of disinvesting for the purpose of making payments to beneficiaries. On the other hand, transaction costs incurred in order to shift funds among particular assets in response to changing expectations could be avoided by a more passive policy. Returns on common stock portfolios should be judged with avoidable costs included and unavoidable costs excluded.

Management fees should not be considered in measuring rates of return for diagnostic purposes. The purpose of the diagnosis is to evaluate the skill of the investor in judging the prospects for particular stocks, and the management fee is not relevant for that evaluation. Obviously, the size of the management fee will be taken into account in judging the wisdom of continuing to retain an adviser or trustee, but the fee itself should not be allowed to cloud the evaluation of performance.

If the actual portfolio of common stocks is riskier than the market as a whole, the bench mark is harder to define. Sharpe's capital market line provides the theoretical bench mark based on the linear extrapolation of the line between the risk-free asset and the portfolio of risky assets. The linear extrapolation is based upon the assumption that investors can borrow at the same rate as the federal government and that the rate is independent of the amount borrowed. Neither of those assumptions is valid. The invalidity is not a serious deficiency of Sharpe's capital asset pricing model in its more general role of explaining the relationship between the risk of particular assets and their rates of return, but it can be a significant blemish in defining a bench mark for the purpose of evaluating an investor's skill in selecting common stocks.

 

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Understanding Stock Transaction Costs

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This article was published on 2010/11/13