Why you should care about investment costs: A risk-adjusted utility approach

Under the assumption of zero correlation between cost ratios and expected investment returns we analyze the impact of proportional investment costs. We consider a constant relative risk aversion investor optimizing expected utility from terminal wealth and identify, in addition to the direct effect due to the additional costs incurred, an indirect effect. The indirect effect is due to lost investment opportunities and a less risky stock position induced by investment costs. By use of an indifferent compensation measure, defined as the minimum relative increase in the initial wealth the investor demands in compensation to accept incurring investment costs of a certain size, we quantify the impact of investment costs. We obtain for realistic parameters that the indirect effect is between half and the same size as the direct effect, and that the investment decision seems to be of very little importance compared to the size of the investment costs.