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Conditional portfolio allocation: Does aggregate market liquidity matter?

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  • Bazgour, Tarik
  • Heuchenne, Cedric
  • Sougné, Danielle

Abstract

This paper investigates how aggregate liquidity influences optimal portfolio allocations across various US characteristic portfolios. We consider short-term allocation problems, with single and multiple risky assets, and use the nonparametric approach of Brandt (1999) to directly express optimal portfolio weights as functions of aggregate liquidity shocks. We find, first, that the effect of aggregate liquidity is positive and decreasing with the investment horizon. Second, at daily and weekly horizons, this effect is weaker on allocations in large stocks and gets stronger as we move toward small stocks, regardless of the other stock characteristics, suggesting that liquidity is the main concern of very short-term investors. Third, conditional allocations in risky assets decrease and exhibit shifts toward more liquid assets as aggregate liquidity worsens. Overall, conditioning on aggregate liquidity yields empirical results that are consistent with the so-called flight-to-safety and flight-to-liquidity episodes. Finally, we propose a simple tactical investment strategy and show how aggregate liquidity information can be exploited to enhance the out-of-sample performance of long-term strategies.

Suggested Citation

  • Bazgour, Tarik & Heuchenne, Cedric & Sougné, Danielle, 2016. "Conditional portfolio allocation: Does aggregate market liquidity matter?," Journal of Empirical Finance, Elsevier, vol. 35(C), pages 110-135.
  • Handle: RePEc:eee:empfin:v:35:y:2016:i:c:p:110-135
    DOI: 10.1016/j.jempfin.2015.10.004
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    2. Giuseppe Buccheri & Davide Pirino & Luca Trapin, 2021. "Managing liquidity with portfolio staleness," Decisions in Economics and Finance, Springer;Associazione per la Matematica, vol. 44(1), pages 215-239, June.

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    More about this item

    Keywords

    Aggregate market liquidity; Portfolio choice; Nonparametric methods;
    All these keywords.

    JEL classification:

    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions

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