Abstract
Many important asset classes are illiquid in the sense that they cannot be traded. When including such illiquid investments into a portfolio, portfolio decisions take on an important dimension of permanence or irreversibility. Using a continuous-time model, this extended abstract shows that this irreversibility leads to portfolio proportions being stochastic variables over time as they can no-longer be controlled by the investor. Stochastic portfolio proportions have major implications since they can change portfolio dynamics in a fundamental way. In particular, it is shown that stochastic proportions implied by illiquidity increase overall portfolio risk. Interestingly, this effect gets more pronounced when the return correlation between the illiquid and liquid asset is low, i.e., the increase in portfolio risk caused by illiquidity is inversely related the return correlation of the illiquid and liquid assets.
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