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

Project Start:01/2016
Researchers:Adrian Buss, Raman Uppal, Grigory Vilkov
Category: Financial Markets
Funded by:LOEWE

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?