Integrating Illiquid Assets into the Portfolio Decision Process
Posted: 31 Aug 2010 Last revised: 15 Sep 2011
Date Written: August 30, 2010
We consider the issues associated with modelling the decision to invest in an illiquid asset, such as real estate, over an extended period of time. Markets for illiquid assets tend to display certain characteristics: e.g. significant time-till-sale and correlation in the rates of return over time. More importantly, since the liquidity of a market cannot be an issue if an investor never needs to liquidate an asset, we focus on how the liquidity of a market interacts with an individual’s uncertain need to liquidate.
We show that the optimal strategy is state-contingent, if possible. We also show that the penalty associated with an illiquid investment depends on the characteristics of other assets being held in the portfolio, on the characteristics of liquidity shocks and on the interaction between time and behavior. We show that borrowing to pay for a liquidity shock cannot overcome all of the costs of owning an illiquid asset. In contrast, borrowing at t=0 benefits from the complementarity in the assets. In a simpler model, we show that the portfolio perspective makes illiquid assets more valuable to an investor with a longer time horizon.
Keywords: liquidity, portfolio, real estate, holding period, autocorrelation, transaction cost
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