It is often said in investment, that asset allocation is key. This means that it is asset allocation that drives the performance of any portfolio of investments. When taken at a higher level, there are indications that many portfolios are allocated between liquid and illiquid investments. But what are liquid and illiquid investments, and what are the differences? When the word “liquidity” is used in investment, it simply means the ease or ability to turn an investment asset or security into cash without losing much of its value. In essence, cash is the most liquid of all investment assets, while real estate property is almost the most illiquid.
The fact that cash is the most liquid, while property is the most illiquid, implies that there is a wide range of degrees of illiquidity or liquidity among asset classes. While treasury bills are very liquid, long term bonds are not as liquid, especially if they are long term bonds of companies that are either unknown or are financially unstable. Treasury bills and long-term bonds are both fixed income securities, but one is more liquid than the other. In the same way, publicly-traded equities are more liquid than private equities. That means that even among same asset classes or types, degree of liquidity differs.
Risks of investing Illiquid assets
Asides the fact that an investor may not readily convert the value of an illiquid asset to cash as at when required, there are other risks that go with illiquidity. Because the holding period of illiquid assets is longer than that of liquid assets, an investor is exposed to increased volatility, fluctuations in interest rates and changes in economic conditions, among other risks. In addition to that, an investor has a higher opportunity cost with illiquid assets because he or she will have to tie down his or her money in the illiquid asset for a longer time.
Importance of Liquidity in Investing
Given the dynamic nature of stock markets around the world, there is no gainsaying the fact that liquidity matters. One of the benefits of liquidity generally is that it leads to pricing transparency, which helps in valuing assets. On the other hand, liquidity offers investors the flexibility they need to trade on their assets.
The price of investing in Illiquid assets
If illiquid investments are not easily convertible to cash, why would anyone be interested in such assets, as an investment. The reason is that those who have the risk appetite and tolerance to invest in illiquid assets and the patience to wait for those investments to come to maturity or fruition, get compensated, oftentimes handsomely. This compensation is what is called liquidity premium. There is liquidity premium in most investments but it is more pronounced in illiquid assets. For example, when you look at a typical yield curve, you will discover that a normally shaped yield curve is upward sloping.
This means that bonds that have longer maturity and are therefore less liquid than short maturity bonds, compensate the investors with higher interest rates or yield. This is because longer-dated bonds carry higher risk and rewards investors for the added risk with the added yield, just like illiquid assets carry higher risks than liquid assets and as such, rewards investors with some liquidity premium. It is these added or magnified investment risks which call for higher liquidity premiums that an investor should demand when investing in illiquid assets.
Illiquid assets are good for diversification
It is often said that portfolio diversification is better achieved when assets that are not perfectly positively or negatively correlated are held together. Therefore, the low beta and low correlation between publicly-traded securities and illiquid assets makes investments in illiquid assets good ingredients of investment diversification. Investments with low beta, help cushion volatilities that emanate from the mainstream markets. Correlation is a statistical measure of how two or more variables move or change in relation to each other, while beta is a measure of the relationship between changes in the stock market and other investments.
The need for proper Asset Mix
It may be tempting to invest in illiquid assets like property, gold, vintage cars, stamp collections or artefacts, because of the premiums that come with them. It may also be tempting to shy away from them because of the additional risks involved. That is why some investors try to strike a balance in their asset allocation or asset mix between investing in liquid and illiquid assets. It is advisable to keep a portion of your investment in liquid assets so that they are at your beck and call, whenever you need to convert them to cash. It is also advisable to have some assets in illiquid assets so as to take advantage of the premiums that they generate.
Is Illiquid Investment good for you
Though I have noted that illiquid investments are good to have in a portfolio to achieve a good asset mix and diversification, it may not be good for every investor. It is good for those investors that have high-risk tolerance, high-risk appetites, high rate of return expectations, and with long investment horizon. Remember, invest according to your risk chemistry.