Investors love to talk about financial liquidity. And if you peruse the various online financial discussion boards you’ll discover a theme.
High liquidity is good and low liquidity is bad.
But is this true? At the very least it’s a gross oversimplification. And at worst, it’s propaganda designed to keep you heavily invested in high-commissioned paper assets.
What is Financial Liquidity?
Liquidity refers to the ease with which one can buy or sell assets at their current market value. Lack of liquidity refers to assets that can’t readily be sold for cash.
Cash is universally accepted as the most liquid asset class. However, there are other highly liquid assets like stocks, mutual funds, and money market funds.
Illiquid assets are things like:
- Real estate property
- Private company ownership
What you should know about Financial Liquidity
The advantages of liquidity are obvious. Being able to sell off an investment in a short period of time and access its cash value has its benefits. Some stock investors utilize that liquidity to periodically rebalance their portfolio or to do tax-loss harvesting.
However, if you find yourself selling off your assets for immediate cash needs then you may not have a large enough emergency fund or adequate enough insurance.
As obvious as the benefits of liquidity are, the downside of financial liquidity may not be as obvious.
Financial Liquidity has a downside
When constructing a portfolio, it’s important to have assets that are liquid. However, it may not be wise to be 100% liquid. The reason I say that is because there are downsides to liquidity.
Liquidity can undermine a disciplined investment plan. For example, liquidity can exacerbate emotional investing both out of fear and out of greed. Financial liquidity can also lead to lower returns as investors miss out on potential liquidity premiums that can come with illiquid assets. Let’s dive into this further.
The DALBAR Effect
DALBAR is a market research firm that has been studying investor behavior for years. In 1994 they produced their inaugural Quantitative Analysis of Investor Behavior (QAIB). In their words, “QAIB has measured the effects of investor decisions to buy, sell and switch into and out of mutual funds over short and long-term timeframes.”
What they’ve found every year since its inception is that investor behavior leads to underperformance in the market in comparison to the index. In other words, the financial liquidity of the market allows investors to execute bad decisions. They tend to buy toward the top of a market out of irrational exuberance and sell toward the bottom out of fear of losing it all.
The volatility of the market cycle produces a whole range of emotions that lead to an underperformance within the market largely due to the liquidity of the market. The research firm DALBAR documents this underperformance annually.
As their research clearly shows, emotional decisions coupled with market liquidity lead to an overall underperformance (5.96% return vs. 7.43% return from the index).
Investors Chasing Return
Just as DALBAR has shown time and time again, financial liquidity enables investors to make bad decisions. One category of bad decisions is chasing a return. How many times have you heard someone say that they sold off a percentage of their stocks or mutual funds to buy something else?
Oftentimes, that something else wasn’t part of their long-term plan. Typically it’s the flavor of the month. Maybe it’s a hot stock pick or perhaps it’s a new promising asset class positioned to take off. Perhaps it’s art or cryptocurrency or something else.
Illiquidity protects people from making irrational decisions like chasing returns or becoming enamored with shiny object syndrome.
Liquidity Highlights Investor Ignorance
As mentioned earlier, cash is the most liquid asset class. And you’d think that coming into a huge financial windfall of money would create a lifetime of financial freedom. However, research shows that whether it’s lottery winners or NFL players, the financial liquidity of cash only magnifies one’s financial woes. Kiplinger reports that 78% of NFL players are either in severe financial distress or have gone bankrupt within two years of retirement. They go on to report that 60% of NBA players experience financial ruin within five years of retirement.
These individuals could benefit from a disciplined approach to investing that included some percentage of illiquid assets.
Financial Liquidity and the Lessons of Allen Iverson
While having a portfolio that contains liquid assets is important, it’s clear that millions of people have fallen victim to the downsides of that liquidity. Probably the poster child for this is Allen Iverson.
For those who don’t know, Allen Iverson was one of the best point guards to ever play in the National Basketball Association. Over a fourteen-year career, he was paid handsomely for his talents. He retired from basketball in 2010 having made $200 million. By 2012 he was broke.
As good as Allen was at basketball, he obviously didn’t have a handle on his finances. Allen frequently dealt in cash and spent it as fast as he could make it. Whether it was cars, jewelry, or clothing Allen spent extravagantly. He didn’t spend everything on himself either. He was famous for lavishly spending on friends and family as well.
Financial liquidity led to his economic collapse. But fortunately, financial illiquidity saved him from becoming destitute. He had one asset that he couldn’t fritter away. It happened in 2001 when Iverson signed an endorsement deal with Reebok. The deal was structured to pay him $800,000 a year for life and supplied a trust fund worth $32 million that he can’t access until he’s 55 in the year 2030.
The lack of liquidity in that deal has provided Iverson with a lifelong income stream and a second chance at real wealth in the year 2030. Hopefully, he has learned from his mistakes.
Loss of a Liquidity Premium
Investments that don’t have financial liquidity tend to pay a liquidity premium. A liquidity premium is simply extra compensation that is paid for investing in an asset that can’t easily or quickly be cashed in.
Probably the easiest way to understand a liquidity premium is to think about bonds. Short-term bonds typically pay less than long-term bonds. The higher return gained from a longer-term illiquid investment is the liquidity premium.
It’s your opportunity to gain enhanced returns.
Financial Liquidity and Modern Portfolio Theory
Financial liquidity is neither good nor bad. Instead, it is a feature of every investment that one should consider before investing. Modern portfolio theory revolves around owning a range of assets that diversify one’s portfolio while maximizing the return given one’s risk tolerance.
For that reason, many people don’t carry all financially liquid assets. Nor do they carry all financially illiquid assets. Instead, they retain a mix of the two to achieve the results they are looking for.
There are downsides to liquidity. And being overweighted in financially liquid paper assets can make you vulnerable to those downsides. If you find yourself in that situation, then you would be wise to learn more about multifamily real estate.
Using Illiquid Real Estate Investments To Balance Your Portfolio
Liquidity is neither good nor bad. Everyone should have liquid assets in their portfolio. However, being all liquid or all illiquid can be risky. Instead, it’s better to balance assets in conjunction with your investment goals and risk tolerance to include both liquid and illiquid assets.
Multifamily real estate is considered an illiquid asset class. And investing in this asset class could help balance out a portfolio that is too heavily weighted with stocks, mutual funds, and cash.
Multifamily real estate has a long history of superior returns. In fact, apartment returns have enjoyed high (stock-like) returns coupled with low (bond-like) risk. That’s why they’ve had a risk-adjusted return (Sharpe ratio) that has outperformed both stocks and bonds over the last two decades.
If you’re not investing in apartments, perhaps it’s time to learn more. 37th Parallel Properties utilizes a fund model in which one can invest fractionally in direct real estate for diversification, cash flow, and the potential for appreciation.
Contact us today and let us know how we can help you.