Is Liquidity Worth the Price?

LiquidityLiquidity is a sacred cow among the investing professional class and the importance of being able to sell and redeem an investment at a moment’s notice is a cornerstone of presumed investor safety and a hallmark of modern investing. In fact, improving liquidity has been a goal of markets and it’s a major achievement that there isn’t a commonly held mutual fund, ETF or stock that can’t be sold at the drop of a hat.

But in the same way that we can overemphasize the benefits of some health trends to the point of excluding other good for you foods, (I’m looking at you gluten free diet) the assumed exclusive positive benefits of liquidity can crowd out some very reasonable reasons to seek investments with low or limited liquidity.

Why would you choose an investment that can’t be sold easily? It’s worth pointing out all the ways that liquidity make investing worse. Volatility is increased by liquidity. High frequency trading, ETFs and trading platforms that let novice investors monitor the ups and downs of the market provide liquidity while magnifying risk. Sudden events best ignored become focal points for sell-offs. Liquidity is almost always the enemy of cooler heads.

HFT

Liquidity also costs money. For investments that are traditionally illiquid, like some bonds and GICs, redeemable options often trade at a discount. According to RBC’s own website the difference between a redeemable and non-redeemable GIC is 25 bps ( a quarter of 1%), which doesn’t sound like much, but when rates are as low as 1.5% for a five year GIC that is a 16% reduction in return.

Picture of the early Dutch stock market

Picture of the early Dutch stock market

The principle of investing has been that buying and holding something over a period of time would result in returns in greater excess than the rate of inflation. That rate of return is based on the associated risk of the enterprise and how long the investment should be held for. But into this mix we have also come to value (greatly) the ease with which we can walk away from an investment. It is the underpinning of a stock market that your commitment to a corporate venture need not be you, but that your financial role can be assumed by someone else for a price (your share).But that feature has come to dominate much of what we both value and hate about investing. Canadians are relieved to know that can sell their investments on short notice, protecting them from bad markets or freeing up cash for personal needs. But by extension things like High Frequency Trading use that same liquidity to undermine fair dealings within markets.

Are there reasons to not choose a liquid investment (aside from your house)? I think the answer is yes. For one thing we may put an unnatural value on liquidity. We pay for its privilege but we rarely use it wisely. The moment we are tempted to use liquidity to our advantage we usually make the wrong choice. Selling low and buying high are the enemy of smart investing, but all too often that is exactly what happens. Every year DALBAR, a research firm, publishes a report detailing investor behavior and its results are sobering to say the least.

Poor investor decisions have led to chronic underperformance by “average investors”. The inability to separate emotions from investing, and the ease with which changes can be made have led to meager returns. In the 2014 study showed that the “average investor” 10 year return was a paltry 2.6%, nothing compared to the return of most indices. That return got surprisingly worse over time, with a 2.5% annualized return over 20yrs and 1.9% over 30. Reduced liquidity could inadvertently improve returns for investors by simply removing the temptation to sell in poor markets; in those moments when our doubt and emotions tell us to “run”.

This is from the 2014 DALBAR QIAB, or Quantitative Analysis of Investor Behavior.

This is from the 2014 DALBAR QIAB, or Quantitative Analysis of Investor Behavior.

So what types of investments are typically “illiquid”? Such products are normally reserved for “accredited investors”, or investors that have higher earnings or larger net savings. These deals are traditionally considered riskier and would be unsuitable for a novice investor (unfamiliar with the risks) or ill-suited to someone who might need to depend on their savings on short notice. That makes a lot of sense and any manager worth their salt would tell you that you shouldn’t tie up your savings if you might need them. But it is worth considering whether we have let our obsession with the convenience of liquidity undermine our goals as investors. Something to consider next time the urge to sell in bad markets comes upon you.

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