TITLE:
Improving Portfolio Selection by Balancing Liquidity-Risk-Return: Evidence from Stock Markets
AUTHORS:
Eder Oliveira Abensur, Wesley Pompeu de Carvalho
KEYWORDS:
Asset Allocation, Bid-Ask Spread, Investor Preference, Liquidity, Portfolio Optimization
JOURNAL NAME:
Theoretical Economics Letters,
Vol.12 No.2,
April
12,
2022
ABSTRACT: The Modern Portfolio Theory was mathematically
structured on the basis of the risk-return tradeoff: in other words, the
riskier the investment, the greater the
required potential return. Traditional portfolio optimization models, however, implicitly consider that all assets can be traded at any time and in
any quantity, which is unrealistic. The aim was to propose a two-stage method
that includes the prior classification of liquidity based on the bid-ask spread
and a mathematical optimization model that uses liquidity as a defined
participation constraint. Simulations were carried out using twenty years of
data from the American (NYSE) and Brazilian (B3) stock exchanges. The results
showed that the method developed offers a broader range of the alternatives that
comprise the MV model with a more realistic approach to liquidity. The proposed method can form portfolios that respect the
risk-return rules once the investor’s risk profile has been defined,
making it a useful recommendation tool for institutional investors. From a
conservative point of view, the developed method also showed the potential for
reducing uncertain sales by 10.3% on average.