#### Date of Original Version

Winter 2010

#### Type

Article

#### Rights Management

Copyright 2012 University of Illinois

#### Abstract or Description

A model for optimal consumption and investment is posed whose solution is provided by the classical Merton analysis when there is zero transaction cost. A probabilistic argument is developed to identify the loss in value when a proportional transaction cost is introduced. There are two sources of this loss. The first is a loss due to “displacement” that arises because one cannot maintain the optimal portfolio of the zero-transaction-cost problem. The second loss is due to “transaction,” a loss in capital that occurs when one adjusts the portfolio. The first of these increases with increasing tolerance for departure from the optimal portfolio in the zero-transaction-cost problem, while the second decreases with increases in this tolerance. This paper balances the marginal costs of these two effects. The probabilistic analysis provided here complements earlier work on a related model that proceeded from a viscosity solution analysis of the associated Hamilton–Jacobi–Bellman equation.

#### Published In

Illinois Journal of Mathematics, 54, 4, 1239-1284.