Abstract - The Risk of Joint Liquidation and Portfolio Choice: Diversity instead of Diversification!

Investors in financial markets often have to liquidate when the value of their portfolio
has fallen significantly. When many investors have to do so at the same time, prices will typically be depressed (“fire-sales”, “crashes”). I show that this has important implications for investors’ optimal ex-ante portfolio decisions. In particular, it becomes rational for investors to forego diversification benefits. The reason is that the risk of having to liquidate jointly gives investors an incentive to hold diverse portfolios. Investors hence (collectively) invest in all possible portfolio allocations. Some investors even optimally hold completely undiversified portfolios. I also derive a diversification-irrelevance result: in equilibrium an investor’s pay-off (net of the endogenous costs of liquidation) is independent of the diversification of his portfolio. There are also consequences for the pricing of assets. An investor has a lower pay-off from investing in assets held by many investors subject to liquidation risk, which is because this increases the risk that he has to liquidate at a time when many others do so as well. Such assets are hence traded at a discount.

Wolf Wagner
Tilburg University
17.Jun 2008

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