Whether you’re just getting started as an investor or you sit on the precipice of retirement, liquidity of your assets can play a crucial role in your financial picture. Unfortunately for many investors, maintaining enough liquidity is too often an afterthought until its most needed.
Below are a few keys we feel every investor needs to know about liquidity and how to avoid common investing mistakes.
What is Liquidity?
Before we dive into specifics about liquidity, it’s important that we start by defining the term.
Put simply, liquidity is your ability to convert an asset into cash. In other words, liquidity describes how easy it is to buy and sell a particular asset.
Some assets are much more liquid than others. For example, cash is considered the most liquid assets you can own. On the other end of the spectrum sits jewelry, collectibles, and real estate. These investments can require substantial time and effort to be exchanged for cash (particularly at fair value).
Why is Liquidity Important for Investors?
An asset’s liquidity, in many ways, reduces the risk associated. A good rule of thumb for an investor is that, in exchange for reduced liquidity, you should demand some form of compensation.
Many investors prefer to invest only in liquid assets — like stocks — that are easy to sell because they know there’s always an ability to exchange them for cash.
For others, the return potential some investments present may be enough to warrant reduced liquidity. The key is proportion. Less liquid investments, by themselves, aren’t bad. But if owned disproportionately, they can present significant risks for an investor.
Common Investments with Limited Liquidity
There are a multitude of assets that offer limited liquidity, including real estate, private placements, and annuities. Each, on its own, has merits for a segment of the investing public.
On the other hand, far too many investors “paint themselves into a corner” because they fail to fully consider the scale of their less-liquid holdings, fail to understand the terms of liquidity, or because an offering fails to deliver the liquidity initially anticipated.
Real estate is the most common investment that people own that fits the bill as “less liquid.” Most recognize that when money is tied up in real estate, it often takes time to get it out. Unfortunately, the liquidity (both price and timing) are fully dependent upon a buyer. As the adage goes, a piece of real estate is only worth what you can sell it for!
When investing in real estate, you are expecting the property to increase in value or to produce income (or both). Along with the benefits of real estate investing come the potential that it may decline, and you may incur unexpected costs along the way.
Investing in real estate can require patience and should be coupled with a basket of other more liquid investments. When emergencies arise, real estate is typically not the asset you want to be forced to sell for liquidity.
For companies looking to raise capital quickly, private placements are an alternative to initial public offerings. Private placements allow companies to sell shares to a small number of investors, but these investments are high risk and can be challenging to sell.
Unlike shares on the public market, with private placements, only certain accredited investors can purchase shares from private placement offerings, and it may be difficult to find a qualified investor who’s interested in your shares.
While private ownership positions can provide great opportunities, making sure not to over-concentrate in such investments is the single best way to avoid a liquidity crisis.
Annuities are contracts between an insurance company and an investor. Annuities are among the least understood and most widely held investments, and they are most commonly targeted toward retirees. Rarely can an annuity be explained simply. Most are quite complicated even for the person selling it and many have extremely high associated expenses.
The allure of an annuity is its guarantees. Guarantees of income, death benefits, and more are available — but none without terms that protect the insurance company as well. Typically, liquidity is the key “give up” when buying an annuity.
Unfortunately, when doing business with an insurance company it’s critical to understand EXACTLY how the liquidity works. Once you put your money into an annuity, it can be almost impossible to access that money in case of an emergency.
What Happened in 2008
For most investors, 2008 was a year to forget! The stock market meltdown was paired with an equally painful liquidity crisis. At the time, the chance of banks closing for days or weeks was palpable, and banks had an urgent need for cash, making it difficult for people to borrow money from banks.
Real estate holdings fell precipitously in many markets and buyers were hard to find. Those who were buying were only searching for bargains because there were enough in a forced-sell position.
Without ready access to capital, many people realized that their portfolios lacked proper liquidity and began to panic. A tough lesson to learn and one we should never forget!
Liquidity and Today’s Financial Landscape
More than 10 years after the financial crisis, your liquidity is still vitally important. Before you make an investment, consider how long it would take you to get your money back out and if you could live without your money for that long.
All investment involves risk, but overweighting holdings of illiquid assets can be extremely risky. Make sure the compensation offered is sufficient for the liquidity being offered.
Head Investment Partners
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