The Optimal Portfolio Weight for Real Estate with Liquidity Risk and Uncertainty Aversion

Abstract:     
In this paper we investigate the portfolio implications of liquidity costs and uncertainty aversion across asset classes. In many cases, financial securities such as equities trade in active markets in which equity owners can liquidate their holdings quickly and with little price concession. In contrast, real assets, such as commercial real estate, may take a substantial amount of time to sell and entail significant transactions costs. For this we focus on literature that considers the impact of uncertainty (as opposed to risk) on portfolio choice (Garlappi, Uppal, and Wang, RFS 2007), and extend this to include a measure of the liquidation costs of assets. In particular, our paper examines the optimal relative weight of real estate in a portfolio when both liquidity costs and the uncertainty regarding sample inputs are considered. We find large increases in the ex-post Sharpe ratio result when liquidity costs and uncertainty aversion are incorporated in portfolio selection relative to a naïve portfolio that ignores liquidity costs and uncertainty.

Number of Pages in PDF File: 37

Keywords: liquidity risk, portfolio allocation, commercial real estate

JEL Classification: R33, G11

working papers series