Where Experience Matters: Asset Allocation and Asset Pricing with Opaque and Illiquid Assets

This project was part of the team project "Social Finance – Finance and the Consumer".

Topic & Objectives

Traditional models of portfolio choice and asset pricing assume that assets are liquid and can be traded without cost. While this is a reasonable assumption for government securities and publicly traded stocks of large companies, there are substantial costs for trading alternative asset classes, such as private equity, stocks of smaller companies, hedge funds, and real estate funds. Consequently, the interval between trades in these assets can span long periods. Moreover, because these alternative assets do not have long histories or regularly observed market values, the returns from investing in these assets are less transparent than the returns from public equity. As it is shown in the literature, investors’ expectations are influenced by their personal experience even in transparent markets.

Given the large and increasing role of alternative assets in portfolios, our objective is to develop a model of asset allocation and asset pricing that takes into account both key characteristics of alternative assets:

(1) trading is costly, and

(2) returns are opaque, and thus, investors’ assessments of these assets depend on their experience. Specifically, when assets can be traded only at a substantial cost, asset-allocation decisions depend not just on current market conditions and investors’ experience, but also past asset-allocation decisions, in addition to expected future experience and trading costs.

Thus, the interaction between opaqueness and illiquidity raises fundamental questions about asset allocation, asset pricing, and their dynamics. How does the interaction between opaqueness and illiquidity affect an investor’s portfolio? Should inexperienced investors hold alternative assets at all, and how should they revise their portfolios over time as they gain experience but face substantial transaction costs? What risks arise because of illiquidity and investors’ inexperience? What are the consequences for asset prices and risk premia and their evolution over time? Finally, what are the dynamics of the optimal risk-sharing arrangement between experienced and inexperienced investors?

Key Findings

• When one asset is opaque, the inexperienced investor recognizes the estimation risk inherent in this asset, and so reduces the initial holdings of this asset. This is accompanied by an increase in the holding of the liquid equity index, and, driven by the desire for precautionary savings, a substantial increase in holdings of the bond. On the other hand, because of market clearing, the experienced investor’s initial holdings of the alternative asset increase with its opacity. Consequently, neither investor holds the fully diversified market portfolio. As investors gain experience, they increase their investment in alternative assets.
• Surprisingly, because of the interaction between inexperience and illiquidity, the inexperienced investor’s optimal initial holdings of the alternative asset can be larger with illiquidity. The intuition for this is that ideally, the investor would like to start with a low holding of the alternative asset and to increase this position over time with gaining experience. However, this would generate substantial trading costs. Accordingly, inexperienced investors that are new to an alternative asset class trade off the higher risk of initial overinvestment versus the cost of future rebalancing. If the transaction cost dominates, it is optimal for such investors to reduce the portfolio tilt away from the alternative asset, and thus, hold more initially.
• Transaction costs also induce portfolio inertia. Consequently, in the presence of transaction costs, the inexperienced investor could end up holding a majority of the alternative asset over time even if being more pessimistic about its growth rate than the experienced investor
• As expected, transaction costs for trading the alternative asset reduce its turnover. This also triggers a decrease in bond turnover because the bond is used to finance trade in the alternative asset. However, the turnover of the liquid risky asset increases because it is used as a substitute for trading the alternative asset. This “spillover” effect can be so significant that the inexperienced investor’s holdings in the liquid risky asset track perfectly the dividend dynamics of the alternative asset, introducing excess correlation and leading to more volatile holdings in the liquid equity index.
• In addition to the economic insights described above, our paper also makes a technical contribution: we demonstrate how to identify the equilibrium recursively in a model where markets are incomplete, the decision to trade or not is endogenous, the risk-free interest rate is endogenous, investors have heterogeneous beliefs that depend on their experience, and preferences are given by Epstein-Zin-Weil utility functions.

Policy Implications

Relative inexperience of households with respect to new assets leads to suboptimal portfolio holdings of households. To mitigate such effects a proper educational program can be implemented to reduce the gap in knowledge between professional investors and retail investors.