MEC SEJ2005-03924/ECON respectively. We also thank the constructive comments of Alfonso Novales,

This paper shows how to introduce liquidity into the well known mean-variance framework of portfolio selection. Either by estimating mean-variance liquidity constrained frontiers or directly estimating optimal portfolios for alternative levels of risk aversion and preference for liquidity, we obtain strong effects of liquidity on optimal portfolio selection. In particular, portfolio performance, measured by the Sharpe ratio relative to the tangency portfolio, varies significantly with liquidity. When the investor shows no preference for liquidity the performance of optimal portfolios is clearly better independently of the level of risk aversion. However, these portfolios display a much lower level of liquidity than the optimal portfolios obtained when recognizing explicitly preference on liquidity