Liquidity and Portfolio Choice: A Unified Approach

Abstract

The authors propose a simple analytical construct for incorporating liquidity into portfolio choice. In cases where investors deploy liquidity to raise a portfolio’s expected utility beyond its original expected utility, the authors attach a shadow asset to tradable assets. In cases where investors deploy liquidity to prevent a portfolio’s expected utility from falling, the authors attach a shadow liability to assets that are not tradable. This construct lets investors determine the optimal allocation to illiquid assets. Alternatively, investors can use this construct to estimate the premium an illiquid asset requires, or the degree to which they must benefit from liquidity in order to justify forgoing investment in illiquid assets. This approach improves on other methods of incorporating liquidity into portfolio choice in four fundamental ways. First, it mirrors what actually occurs within a portfolio. Second, it maps units of liquidity onto units of expected return and risk, so that investors can analyze liquidity within the same context as other portfolio decisions. Third, it distinguishes absolute illiquidity from partial illiquidity and lets investors address these attributes within a single, unifying framework. Fourth, it recognizes that liquidity serves not only to meet demands for capital, but to exploit opportunities as well, thus revealing that investors bear an illiquidity cost to the extent that any fraction of a portfolio is immobile.

TOPICS: Portfolio construction, passive strategies, statistical methods