The Cost of Liquidity

The Cost of Liquidity


Everything has a cost. As is often said, there’s no free lunch. How much easier are our lives thanks to inventions like smartphones and the internet? I hate to imagine my life without either; yet, each has its price—less privacy, less alone time, and information overload (or TMI as those texting kids like to say). Watch any television commercial for a prescription medicine designed to cure what ails you, and by the end of the 30-second spot, the narrator will kindly remind you that the cure has a cost in the form of a potential host of side effects.

When explaining our investment philosophy to new clients, we always list liquidity as one of the benefits, and it certainly is a benefit. We only invest in mutual funds and ETFs—one of the key reasons being that, as trend followers, we need to be able to move in and out of an investment quickly if the trend changes course. Additionally, if a client calls with a redemption request, we can sell out of a security at a fair price and have the money available to them in as little as one business day.

With illiquid investments such as real estate, private equity, or land, it can often take months or years to sell, and if you need to sell quickly, you will likely have to sell at a significant discount to fair value. So liquidity certainly has its benefits, but it also has a cost.

Simply put, the cost of liquidity is the price volatility that you have to deal with on a daily basis. Because a market always exists for liquid securities, there are always trades occurring, which means that the price is constantly changing—day-to-day in the case of mutual funds or second-to-second in the case of stocks and ETFs. Those constant price changes result in volatility, which is one of the toughest things to deal with as an investor—to see your assets fluctuate in value in real time, especially when that fluctuation is -occurring on the downside more than on the upside.

Given that many of our clients share that they are worried that we are in for another volatile year in 2012, we thought it might help to provide some tips to deal with, what can be, wild fluctuations in the value of your liquid investments.

Invest in Companies Not Pieces of Paper

It can be easy to forget what you are investing in when you buy stocks. Stocks are not just pieces of paper that fluctuate in price based on supply and demand in the marketplace. If they were, there would be reason to be concerned about price fluctuations. After all a piece of paper has no intrinsic value; you would simply be holding out hope that someone would be willing to pay more for it than you did (a.k.a. The Greater Fool Theory). But stocks are not just pieces of paper; they represent ownership in actual companies. Those companies (presumably in most cases) have intrinsic value in that they have earnings, cash flow, dividends, and assets. So when the market drops significantly over a few months or nearly all the stocks in the S&P 500 fall in unison on any given day, remind yourself that you own companies. Certainly you wouldn’t sell your company solely because it lost value last week or because someone quoted you a price that was 10% less than what you could have had last month.

All Assets Fluctuate in Price

You may not know it, but the price of your house is fluctuating as you read this. If you own investment real estate or a small -business, the price of those assets are -fluctuating as well. And so is the price of your art. There are transactions going on right now that are changing or confirming the price of all of your assets. In the case of your illiquid assets, you just don’t know about it. If there were an exchange for the real-time pricing of your illiquid assets, you would be experiencing price volatility with those as well—the main difference being that it would seem less likely that you would sell your home, business, or art collection just because the price fell.

Space Out the Peeks at Your Portfolio

We often council our clients to look at their portfolios less frequently, which they have the luxury of doing because they have hired us to watch over it for them. 2011 provides the perfect example of how checking in on your portfolio less frequently can help ease the stress caused by price volatility. The S&P 500 Index started 2011 at 1,257.64. It closed the year at 1,257.60—a difference in price of just -0.003%. While that still would have made a disappointing year due to the lack of return, it is nothing compared to the harrowing experience of watching the market daily in 2011. In that case, you would have experienced a -19.4% correction over just five months, and 21 days in which prices fell by at least 2%, significant stress inducers that were avoidable if you just paid less attention to the stock market.

Like advancements in technology and medicine, we think the benefits exceed the costs when it comes to liquidity, which is why we always list it as a selling point with new clients. But as any good consumer would, it’s important to understand the costs and devise ways to mitigate them. Just got a text; got to run.

Scroll to Top