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-ontingent, 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.
Theories of portfolio selection explore the relationship between the characteristics of assets and an investor’s optimal mixture of those assets. These theories find it convenient to assume that the relevant characteristics of an asset can be summarized by a probability distribution of the rate of return (i.e. changes in the price). Some types of assets cannot be described so easily because of the time and expense needed to sell at any price. These costs imply that the asset is traded in an illiquid market where, at any time, there is a significant trade off between the selling price and the time needed to achieve that selling price (e.g. Anglin, 2006). This classic definition of illiquidity certainly characterises the buying and selling of real estate assets and, at the level of a market equilibrium, a consequence of this characteristic is that the rate of return to holding the asset does not follow a random walk (Case and Shiller, 1989). This characteristic also needs to be given a context for an individual since an individual may not need to sell the asset. This paper notes how models ofinvestment decisions can account for these issues and their consequences.
Download:
Integrating illiquid assets into the portfolio decision process
