From Investopedia- Definition of Liquidity:
- The degree to which an asset or security can be bought or sold in the market without affecting the asset’s price. Liquidity is characterized by a high level of trading activity. Assets that can be easily bought or sold are known as liquid assets.
- The ability to convert an asset to cash quickly. Also known as “marketability”.
Most investors can grasp the concept of liquidity quite easily. They understand that cash in the bank is liquid, meaning they can access it at a moment’s notice. Many also understand that various investments, such as mutual funds and blue chip stocks, are liquid for the most part. You can generally buy today, sell tomorrow (or sell in 5 minutes if necessary!). An investment with more liquidity, all other things being equal, is superior to an investment with less liquidity. However, in the real world, all things are not equal.
This “Ease of Understanding” Can Pose a Serious Risk to Your Financial Health
The problem that presents itself can become a major impediment to making sound investment decisions. This is primarily due to a couple of main issues, polarization and bias, which can infect one’s thinking by becoming “common knowledge”. Some examples:
- “Black or White” Mentality- The easier a concept such as liquidity is understood, the less time an investor will generally spend trying to grasp the variables and nuances associated with that topic. This can cause a blanket perception that the greater the liquidity of an investment, the “better” the investment must be, which is simply not accurate. There are both high and low quality investments across the spectrum of liquidity.
- Bias of Financial Institutions and Product Providers- Just follow the money trail, and it will lead you to the bias, and tell you how your financial product provider is possibly misleading you. If you are being sold GICs from your bank, where a lock-in is required, liquidity will be less emphasised. Your mutual fund provider or stock broker may promote the fact that their products can be converted into cash almost immediately. Your exempt market product provider might scare you by saying that liquidity can be a bad thing, and point to 2008, when being liquid actually hurt you. I am not against the main points and benefits of all sides, just the way they are being promoted to sell certain product-types, which ends up confusing you and taking you off the path to making wise decisions.
For a related article on avoiding costly investment mistakes, click here
The Pros of Liquidity
- As a source of emergency funds when they are needed immediately.
- To provide the ability to raise cash quickly and take advantage of an investment opportunity.
- For stock market investors who want to sell one security and purchase another, take profits, crystallize losses, get in and out of the market, etc. The more active you are, the more liquidity matters to you.
- For mutual fund investors who are perhaps more short-term oriented, or wish to sell a fund to spend the money or invest in something else, or simply like to trade funds.
- There is a sense of security in knowing that you should be able to get access to your funds on short notice.
- The ability to obtain a fair price on the security sold. More liquidity creates a tight buy/sell range, and can prevent you from being taken advantage of by savvy manipulation.
There are some definite pluses to being liquid.
The Cons of Liquidity
- A tendency to create a “gambler’s mentality” exists. Some people trade frequently for the emotional high of it. This can severely erode your ultimate goal, which for many people is to create wealth through substantial long-term returns with the lowest downside risk possible.
- Your broker may feel the need to justify fees and commissions charged by creating trading activity. If the goal is taking care of your money, perhaps it is better to leave the portfolio alone, rather than buy and sell.
- In addition, your mutual fund manager may be questioned for holding stocks in the portfolio, and not making changes. Although doing nothing might be the best thing for the fund, the manager is judged by short-term quartile performance, which can be justified more often with frequent trading. This can run contrary to the reason you purchased the fund in the first place.
- The stock market, with immediate liquidity, in theory provides the fairest price, with all available information about the company and its assets built into the price “this instant”. One huge potential drawback is that a savvy investor will find it much more difficult to add value. For example, an investor who can acquire assets on a private basis, in an area of his/ her expertise, with high barriers to entry, has the ability to purchase quality at a significant discount to intrinsic value. When executed properly, the purchase of private, illiquid assets, at a discount, can lower risk and enhance return. In many cases, fewer eyeballs examining assets can benefit the investor. This is one of the major drawbacks of being liquid. It is also one of the reasons there is only one Warren Buffett: Making a fortune in the stock market is extremely tough!
How To View Liquidity Properly
If you have read any of my other articles you will notice a few common threads, those being education, and the elimination of bias, when making investment decisions. Because this bias is kind of like a cancer, which can severely devastate you financially, I am going to keep harping on this. The messages you receive from many mainstream financial institutions are simply wrong.
To learn how one investors was able to view liquidity properly, and make wise choices, click here.
You want to first assess how much money you will require, at a moment’s notice, for the reasons stated above. Is it 10, 20, 30% of your portfolio, or more? This is going to be an individual decision that you discuss with someone who can help you without bias.
In all likelihood, the majority of your portfolio will not require liquidity for several years. This opens up the possibilities to many additional liquid and illiquid opportunities. For practical purposes, it is quite possible that investment decisions geared towards long-term goals do not have to be burdened with the issue of liquidity as a major concern. In these instances, you can significantly widen the landscape of potential investment opportunities, and stand a much greater likelihood of achieving a successful outcome. This includes generating the lowest overall portfolio risk, creating multiple income and growth opportunities, inflation protection, greater confidence in the direction of your finances, and “peace of money mind”.
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