Portfolio Choice with Illiquid Assets

We investigate how the inability to continuously trade an asset affects portfolio choice. We extend the standard Merton model to include an illiquid asset that can only be traded at infrequent, stochastic intervals. Because consumption is financed through liquid wealth only, the presence of illiquidity leads to increased and state-dependent risk aversion. Illiquidity leads to under-investment in both the liquid and illiquid risky asset, relative to the standard Merton (1969) case. We demonstrate that the effect of illiquidity can be quantitatively large, because in contrast to transaction costs models, the shadow cost of illiquidity is unbounded. The presence of liquidity risk distorts the allocation of the liquid and illiquid assets even when liquid and illiquid asset returns are uncorrelated and the investor has log utility. JEL Classification: G11, G12