Optimal Portfolio Selection: The Role of Illiquidity and Investment Horizon

Ping Cheng, Zhenguo Lin and Yingchun Liu

Journal of Real Estate Research, 2017, vol. 39, issue 4, 515-536

Abstract: Modern portfolio theory (MPT) is a single-period model developed for the efficient securities market, in which asset prices are implicitly assumed to follow a random walk. It is widely agreed that real estate does not fit into the efficient market paradigm; however, mixed-asset portfolio analysis continues to rely on MPT. In this paper, we propose an alternative model that extends the MPT to accommodate multi-period utility maximization, as well as the unique characteristics of real estate such as liquidity risk, horizon-dependence of real estate returns, and high transaction costs. The model is easily implemented. Using real world data, it demonstrates the optimal allocation to real estate in the mixed-asset portfolio is quite in line with the reality of institutional portfolios.

Date: 2017
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DOI: 10.1080/10835547.2017.12091485

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