Inexperienced investors behave differently when it comes to allocating to illiquid and opaque asset. And that different behaviour comes at a cost. That’s the key finding of a new paper by Grigory Vilkov, Frankfurt School of Finance and Management and Adrian Buss, INSEAD; Raman Uppal, EDHEC. In “Where Experience Matters: Asset Allocation and Asset Pricing with Opaque and Illiquid Assets” the authors look at asset allocation and asset pricing for liquid and alternative risky assets which are also opaque and incur transaction costs. In particular, they also look at investors with different levels of experience in evaluating alternative assets.
Notably, inexperienced investors initially tend to invest less in the alternative asset because of “estimation risk”. As a result their portfolios tend to be tilted toward liquid assets. Conversely, experienced investors hold a much greater share of the alternative asset.
The inexperienced investors do tend to boost their holdings as they gain experience however, increases in the transaction cost for the alternative asset can lead an investor to hold a larger share of the asset at the initial date. This is because investors tend to start slow with a new asset class and build up with experience. The problem with this strategy, however, is that is leads to higher trading costs. The authors propose a better way for inexperienced investors to get more comfortable will alternative assets – hold a larger share of it in order to economize on future trading costs.
In addition, the authors find that, because of portfolio inertia induced by transaction costs, inexperienced investors might end up holding a majority of the alternative asset even though he or she might be pessimistic about its growth rate.
The paper was presented at the 2015 Northern Finance Association Conference (September 18-20). You can download it here.