Portfolio optimization with transaction costs : a two-period mean-variance model

In this paper, we study a multiperiod mean-variance portfolio optimization problem in the presence of proportional transaction costs. Many existing studies have shown that transaction costs can significantly affect investors’ behavior. However, even under simple assumptions, closed-form solutions are not easy to obtain when transaction costs are considered. As a result, they are often ignored in multiperiod portfolio analysis, which leads to suboptimal solutions. To provide better insight for this complex problem, this paper studies a two-period problem that considers one risk-free and one risky asset. Whenever there is a trade after the initial asset allocation, the investor incurs a linear transaction cost. Through a mean-variance model, we derive the closed-form expressions of the optimal thresholds for investors to re-allocate their resources. These thresholds divide the action space into three regions. Some important properties of the analytical solution are identified, which shed light on solving multiperiod problems.