Portfolio Choice and the Effects of Liquidity

23 Pages Posted: 26 Jul 2007

See all articles by Ana Gonzalez

Ana Gonzalez

University of the Basque Country

Gonzalo Rubio

University of the Basque Country - Department of Foundations of Economic Analysis I

Date Written: 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 Classification: G10, G11

Suggested Citation

Gonzalez, Ana and Rubio, Gonzalo A., Portfolio Choice and the Effects of Liquidity (May 2007). Available at SSRN: https://ssrn.com/abstract=1003135 or http://dx.doi.org/10.2139/ssrn.1003135

Ana Gonzalez

University of the Basque Country

Barrio Sarriena s/n
Leioa, Bizkaia 48940
Spain

Gonzalo A. Rubio (Contact Author)

University of the Basque Country - Department of Foundations of Economic Analysis I ( email )

Avda. Lehendakari Aguirre 83
Bilbao, Vizcaya 48015 48015
Spain
+34 94 601 3770 (Phone)
+34 94 601 3774 (Fax)