Transaction costs and international portfolio diversification

This paper employs an intertemporal portfolio-choice model that incorporates proportional transaction costs to examine two features of portfolio allocation: the domestic bias of equity holdings and the relationship between domestic and international turnover rates. The model implies that the rate of portfolio diversification decreases as the magnitude of the transaction costs increases. As costs increase, active portfolio reallocation decreases and is replaced by passive portfolio reallocation, which is costless and is accomplished through the realization of capital gains. The international turnover rate is greater than the domestic turnover rate because the average holdings of the international asset are small, not because the volume of trading is large. (C) 1999 Elsevier Science B.V. All rights reserved.