Paper #1035

Title:

Portfolio choice and the effects of liquidity

Authors:

Ana González and Gonzalo Rubio

Date:

May 2007

Abstract:

This paper shows how to introduce liquidity into the well known mean-variance framework of portfolio selection. Either by estimating mean-variance liquidity constrained frontiers or directly estimating optimal portfolios for alternative levels of risk aversion and preference for liquidity, we obtain strong effects of liquidity on optimal portfolio selection. In particular, portfolio performance, measured by the Sharpe ratio relative to the tangency portfolio, varies significantly with liquidity. Moreover, although mean-variance performance becomes clearly worse, the levels of liquidity on optimal portfolios obtained when there is a positive preference for liquidity are much lower than on those optimal portfolios where investors show no sign of preference for liquidity.

Keywords:

Liquidity, mean-variance frontiers, performance, portfolio selection

JEL codes:

G10, G11

Area of Research:

Management and Organization Studies

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